Benjamin Graham

Chapter 2 – The Investor and Inflation

Summary and Discussion – Chapter 2 – The Investor and Inflation
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created November 16th 2013
Last updated November 17th 2013
Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

50-Word Recap

  • There is no clear correlation between inflation and stock-market performance.
  • It is extremely difficult to consistently or accurately predict future rates of inflation.
  • Investors should be skeptical of so-called “inflation hedges”.

Introduction

Graham begins this chapter by noting that “There is no close time connection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices.” [1]

Inflation and Corporate Earnings

How does the inflation rate impact corporate earnings? Corporate earnings have “shown no general tendency to advance with wholesale prices or the cost of living.” [2]

“The only way that inflation can add to common stock values is by raising the rate of earnings of capital investment. On the basis of the past record this has not been the case.” [3]

Graham notes that “public-utility enterprises”, contrary to popular perception, might actually stand to benefit from periods of heightened  inflation because “the very fact that the unit costs of electricity, gas, and telephone services [advance] so much less than the general price index puts these companies in a strong strategic position… They are entitled by law to charge rates sufficient for an adequate return on their invested capital, and this will probably protect their shareholders in the future as it has in the inflations of the past.” [4]

Graham’s reasoning here is as follows:

1. Periods of inflation increase the cost of borrowing money.

2. This increased borrowing cost reduces the return which utility companies receive on their invested capital.

3-A. This reduced return entitles said companies to increase their rates in order to ensure that they receive “an adequate return”.

3-B. At the same time, “the unit costs of electricity, gas, and telephone services” rise at a lower rate than other prices, due to regulatory controls.

Therefore, from 3-A and 3-B, utility companies face the prospect of increasing their rates while at the same time enjoying relatively low increases to their expenses: a formula for profit relative to other economic sectors.

Graham ends this section with a prescient warning against the dangers to placing too much confidence in one’s predictions regarding expected changes to the future rate of inflation:

“…if the investor concentrates his portfolio on common stocks he is very likely to be led astray either by exhilarating advances or by distressing declines. This is particularly true if his reasoning is geared closely to expectations of further inflation. For then, if another bull market comes along, he will take the big rise not as a danger signal of an inevitable fall, not as a chance to cash in on his handsome profits, but rather as a vindication of the inflation hypothesis and as a reason to keep on buying common stocks no matter how high the market level nor how low the dividend return. That way lies sorrow.” [5]

This warning is equally applicable to investments in gold or other commodities; in these circles expected inflation is often cited as a primary justification for continued buying. Indeed, this justification is also used with regard to bitcoin, real estate, and several other “investment” vehicles. Inflation, siren that it is, gets heralded in all number of (at times mutually-contradicting) “investment theses”.

Alternatives to Common Stocks as Inflation Hedges

Graham cautions against the practice of investing in physical objects—“things,” as he puts it—as a way of hedging against inflation. His argument is as follows:

1. Things do not incur dividends (and therefore do not offer compounded returns).

2. Things incur storage costs, insurance costs, and/or risks of theft.

3. The market for things often seems irrational, and in any case it is difficult to understand—much less predict—their price fluctuations.

What Graham is really saying here is that things fall outside the framework of value investing. They are, therefore, not of interest to him, The Intelligent Investor, or our studies.

Conclusion

  • Diversification is key. “Just because of the uncertainties of the future the investor cannot afford to put all his funds into one basket—neither in the bond basket… nor in the stock basket”. [6]
  • The defensiveness of one’s investment practices should increase—not decrease—in line with one’s dependence on one’s investment returns. “The more the investor depends on his portfolio and the income therefrom, the more it is necessary for him to guard against the unexpected and the disconcerting in this part of his life. It is axiomatic that the conservative investor should seek to minimize his risks.”
    [7]
  • Being diversified is always better than being undiversified; even if it is only “the lesser of two evils” at a particular time. “This is what we said on the subject in our 1965 edition, and we would write the same today: “… For reasons already given we feel that the defensive investor cannot afford to be without an appreciable proportion of common stocks in his portfolio, even if we regard them as the lesser of two evils—the greater being the risks in an all-bond [or, conversely, an all-stock] holding.”  [8]

Footnotes
[1] 51.
[2] 51.
[3] 52.
[4] 54.
[5] 55.
[6] 56.
[7] 57.
[8] 57.

 

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