Dear fellow investors,
In a recent interview with CNBC, a reporter asked us why Berkshire Hathaway (BRK) was buying Barrick Gold common stock shares. As a high school and college student in the 1970s, my education was formed during a time of explosive inflation and included the economic problems which came with consistently rising prices. Although that was long ago, after the interview, I decided to look up the definition of inflation to remind myself. We found this classic definition on August 17, 2020:
Inflation: A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.
What kind of cocktail got mixed in the 1960s and 1970s to meet this classic definition of inflation? What kind of cocktail must be mixed today to get us into this classic definition of inflation over the coming decade? What are the investment implications of entering a new era of rising prices, decreased purchasing power and goods shortages?
In the 1960s, the U.S. Government tried to do two things at once. They fought a war halfway around the world which was incredibly expensive (Vietnam War). Simultaneously, we attempted to improve the lot of the nation’s least fortunate through what President Lyndon Johnson called the “Great Society.” Both were massive expansions in government spending which required the U.S. to issue bonds and print money.
During the 1960s and 1970s, demographics put the U.S. in population circumstances which caused goods and services to be in short supply. Oil was cheap in the 1960s, until 79 million baby-boomers replaced 44 million silent generation folks in the 20-35-year age cohort. Waves and waves of 16-year-old Americans got their driver’s licenses. If you want to understand that era, watch the movie American Graffiti.
Oil soared in price from $4 per barrel in the 1960s to $40 in 1981. Gold went up from $35 per ounce to $595 from 1965 to 1981. The chart below does a great job of showing what commodity prices did in the 1960s and 1970s:
The U.S. Government is now fighting the war against COVID-19 and frighteningly high unemployment levels. We have thrown $4 trillion at this war already and we aren’t done yet. Gold is responding like it did in the 1960s and 1970s and was affirmed recently when it was reported that Berkshire bought a chunk of Barrick Gold shares. Oil bottomed when the Saudi Arabians led an effort to use the COVID-19 misery to crush U.S. oil production. This sets up the kind of limited supply the classic definition of inflation requires in its cocktail.
The demographics are perfect for more inflation this time as well. There are 90 million Americans between 23 and 41 years of age. They are forming households later in life than prior generations but are coming out of the woodwork to buy germ-free brand-new homes and are causing home prices, lumber and used car prices to explode to the upside. These millennials are replacing 65 million Gen X folks. When 36% more 30-45-year-old people buy houses and cars, they’ll use more gasoline the next ten years.
What common stock sectors do well in an inflationary environment? Energy, income-producing real estate, banks, home builders and others come to mind. Research from Fundstrat shows that despite the emergence of electric cars and hybrids, gasoline use by millennial Americans is expected to double in ten years. If 90 million American adults use twice as much of a product and there are only 240 million adults in the U.S., you get the cocktail ingredient required in the classic definition of inflation.
Since they are not making more land and millennials now are spreading themselves across the country, we are reminded that real estate has been a very good inflation hedge historically. In fact, for most American families, homes have been their most successful source of net worth in retirement. It makes the homebuilders a good long-term bet despite their recent run up in price. Homes outperform stocks for most households, because of stock market failure.
Interest rates went up from 1965 to 1981. You’ll be shocked to hear that the banks raised lending rates faster than they raised their deposit rates. Now that Buffett has bailed on Wells Fargo (WFC) and JPMorgan (JPM), those of us who have owned the stocks since 2012 are having their faith in the stocks challenged. Banks outperformed in the early stages of the 1960s version of the inflation cocktail. We are patient, but that patience doesn’t last forever.
Lastly, value outperforms growth immensely when the inflation cocktail gets mixed. Price-to-earnings (P/E) ratios in the S&P 500 peaked in late 1972 at 18x P/E and bottomed in 1981-1982 at 6x P/E. This was a 66% contraction in P/E multiples. What could this inflation cocktail do to the Russell 1000 Growth Index, which is starting at 40x P/E? Or the S&P 500 Index which is starting at 24x P/E? The chart below shows the 13-year pounding that the Russell 1000 Value Index took at the hands of the Russell 1000 Growth Index:
Growth stocks have gone up nearly five-fold while value stocks doubled. Despite that fact, value has outperformed growth by 3.5% compounded over the last 94 years as measured by Ibbotson and Associates. Since the inflation cocktail is closely related to value stock outperformance, we are very excited about our future value investing possibilities.
The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.
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