How to overcome inflation

... when a depression does occur it is apt to be shorter than some of the great depressions of the past. It is almost bound to be followed by enough further inflation to produce the type of general price rise that in the past has helped certain industries and hurt others. With this general economic background, the menace of the business cycle may well be great as it ever was for the stockholder in the growth company with sufficient financial strength or borrowing ability to withstand a year or two of hard times, a business decline under today’s economic conditions represents far more a temporary shrinking of the market value of his holdings than the basic threat to the very existence of the investment itself that had to be reckoned with prior to 1932.

- Philip A. Fisher

The words look prophetic as the famous author wrote in his first book "Common Stocks and Uncommon Profits" more than 50 years back.

Warren Buffett has double confirmed this through is own words as a follow up of Burlington Northern Santa Fe Railroad purchase. “I'd be more worried holding cash. I think that if you look at the side effects of the incredible dosage that we've had to give -- and I think that dosage has been 100 percent appropriate; I'm not knocking that. But when you apply the kind of medicine we've applied, you may have sort of unprecedented aftereffects, too. But the one thing about those unprecedented after effects is they're going to be very bad for cash. I would much rather own working assets than have cash in a period that well could become inflationary down the road.”

Now for the small time investors like us what are we supposed to learn from these experts whose quotes are nearly 50 years apart but still mean the same?

1. Cash is not the king during inflationary period. Keeping idle cash is the worst thing to do when the inflation is ruling the roost.
2. If not cash, how about fixed-income securities? While they look better than cash in absolute terms, they are in no way have the power to protect the investor’s capital from the daemon called inflation.
3. How about “real-assets”? A piece of land, which doesn’t earn a penny of rent to the investor or biscuits of gold locked deep inside the bank locker. While these are far better than the earlier two, they still don’t allow them to “earn” an income, particularly if his earnings are poor.
4. Commodities? These are buzz words which appear on the pink magazines over the last few years. As the experts say, commodities seem to have the real protection against the inflation. But caution is advised not to touch this asset class if you don’t know how the commodities behave. I really don’t have a clue on how to price a commodity to see whether they are cheap or expensive.
5. Working Assets? Any asset which has the capacity to earn as it is put to use has the capacity to overcome the effect of inflation. These assets could be classified under soft asset or as a hard asset. If you are consultant, the knowledge you possess is the soft asset which allows you to earn the “rent” for the service you provide. As the inflation rises, you can increase the “rent” nullifying the loss caused by the inflation. The ratio of increase depends on the uniqueness of the soft asset you possess. A real estate property which earns a rental income is a hard asset. The beauty of this asset is it provides the flexibility to increase the “rent” during the inflationary period and also the capital value rises as the years go by. Thus it retains the value adjusted to inflation. Another hard asset is a “good company” which has the financial strength and pricing power in the market. If you have learnt to deal with Mr. Market with respect and caution, and know how to select a good company with the above characteristics, you are pretty much ready to deal with the inflationary situation.
   

While high inflation has a devastating effect on the economy and the poor who are hurt more than others, nearly all the economists and governments and even ordinary people are comfortable with moderate inflation. If you don’t have inflation, the asset you bought ten years back would quote the same price even now. Nearly no one is ready to accept this principle.

How about deflation? Deflation leads to a down word spiral which is hard to control than inflation. In a deflationary situation every consumer knows that the price of a discretionary good will cost him less in next one month than the current price. He will postpone the purchase until he can carry on without buying that goods. This in turn leads to shrinking economic pie and job losses aggravating the pain the consumer is already going through. Japan is a classic example of the deflationary situation which has been aggravated by its political leaders for the past 10 years.