“But it’s not a price-sensitive economy at the moment. And I don’t know exactly how to do in different price indices, but there is more inflation, a lot more inflation than people would have expected. “Just six months or so ago.”
Warren Buffett (Trades, portfolio)
“Yes. And there is a very intelligent man who thinks this is dangerous and this is just the beginning.” –
Charlie Munger (Trades, portfolio)
To say we were surprised by some of the discussions at Berkshire Hathaway (BRK.A, Financially)(BRK.B, Financial) annual meeting would be an understatement. The conversation
Warren Buffett (Trades, portfolio) and
Charlie Munger Inflation-based (trades, portfolio) may have been the most interesting. Buffett and Munger paid tribute to Larry Summers for his willingness to stand alone about the impact of today’s fiscal and monetary policies on prices. We thought this was an ideal time to review Buffett and Munger’s discussion and see what conclusions we could draw.
Buffett responded to a question about the signs of inflation by saying:
“We are seeing very high inflation. This is very interesting. We’re raising prices. People raise prices for us and it’s accepted. Take the house building. that is the largest in the country. So we really do a lot of housing construction. The costs are just up, up, up. Steel costs, they just rise every day. And it wasn’t about the wages yet. The UAW writes a three-year contract, we have a three-year contract, but when you buy steel from General Motors or elsewhere, you pay more every day. And we didn’t expect that. “
Greg Abel followed up on his comments by saying:
“Yes. Warren, I think you raised it, if we look at steel prices, wood prices, any oil supply, there is basically a pressure on those raw materials. I think you said something, Warren, and it really works … back to the raw materials. There is currently a product shortage of certain raw materials. This affects the price and the ability to deliver the end product. But that scarcity factor is also real out there right now as our companies rise to the challenge. “
In my business class at Whitman College, we were taught that quantity of money times speed is price times output (MV = PY). What has happened on a large scale since 2009 has been an increase in the money supply (M). What has countered the increase in money supply has been a decline in pace for much of the past 10 years. We argued to investors in 2009 and 2010 that increasing the money supply back then was like doubling the money in the game of Monopoly but no longer paying for passing Go or free parking. The game would not speed up just because the bank had more money.
To look at it from today’s perspective, we first need to note that the money supply has increased by 24% over the past year. If the speed stayed the same as before, prices would increase by that amount. The data suggest that the pace has continued to slow down over the past year. We still believe that the monopoly analogy can teach us more.
The US Federal Reserve has increased the money at the Monopoly bank. The federal government is distributing more than $ 200 for passing Go and paying hundreds of dollars for free parking through loans, grants, and stimulus checks. In the monopoly context they are willing to pay you money for just being the pawn on the board.
In our opinion, Adam Smith’s invisible hand (aka the market) is beginning to understand this problem faster than economists. Why, you might ask? Investors and business owners have more incentives than academics in government or educational institutions. The economists may come back later and explain why. However, that won’t help you with inflation. The worst thing about inflation is that you don’t know how bad it is until much later.
Where is the game of Monopoly accelerating? It is notable in the raw material, as Abel mentioned. Wood, copper, steel and cotton are all at five-year highs. Buffett spoke on the subject of housing. The housing supply is scarce and therefore has a price inelasticity. If the inputs to our house builders (NVR (NVR, Finance), Lennar (LEN, Finance) and DR Horton (DHI, Financial)), they respond by increasing the price of the house more than their cost.
The economic comeback has caught investors and economists on the wrong foot. As Buffett said, “This economy is 85% in full swing right now, and you’re seeing some inflation and all that, it has responded in incredible ways.” If we were wrong about the economic response from 12 months ago to today, we may not know where we are headed.
We believe housing construction is probably the most interesting look at the inflation issue. It seems we have seen a tectonic shift in housing construction since the pandemic began and the political response. Millennials love homes and an act of God made them the newest suburban immigrants. Baby boomers love houses and don’t move out like previous generations. As a result, the existing supply of homes for sale is at a record low of two months. As an example, the graphic on the right shows the house prices below the existing and new building prices in the 1970s.
Investors argue that real estate will suffer as real interest rates rise. The data from the 1970s suggest the opposite. As real interest rates rose, homes were protected from inflationary pressures, leaving additional compensation for the risks of this era that went beyond the effects of inflation. In other words, inflation showed you more price pressures in other inflationary times, even though affordability declined rapidly.
We discussed this in our investment team. We believe the cost of replacing an existing home is rising faster than the valuation reports can keep up. The replacement costs only rise if the input increases and finished apartments are delayed due to a shortage of skilled workers.
How can this price reaction be so explosive in the short term? Buffett and Abel commented on the material prices. The other point that needs to be considered is the lack of production capacity. As an example of this, we hear of chip shortages on the news, but there are a multitude of products that you have to wait for. The bigger the tickets, the longer you wait. Supply chains are messed up. There is a quick way to stop production and increase it: to increase prices.
Another way of thinking about this story is labor inflation / wages. For the first time since World War II, the state is the main competitor for cheap workers. We hear from public companies like Chipotle (CMG, Finance) and private companies that we interact with make it difficult to find workforce. Dishwashers are an example in restaurants. Bloomberg reported that prices are rising and incentives are being offered. The reason is that the government is competing for these workers with stimulus checks. You can be paid to do nothing. Why go in
It’s like Buffett said in the United Auto Workers (UAW) contract. When the cost of housing, the cost of a car, and the cost of a restaurant rise, it is only a matter of time before workers make claims or companies trying to get their businesses up and running distribute increases to meet labor demand. Below you can see the waiting times for materials and consumables from the ISM.
It has never been so bad in supply chains since 1987. You may want to buy a product and a company may want to make it for you, but it will take more time than it has in the past. The same goods that are produced longer create scarcity. Scarcity creates price pressure. Buffett commented, “Supply chains are screwed up for all types of people, but it’s almost a buying frenzy.”
We’re going to end this piece with a tip of the cap for Larry Summers like Buffett and Munger did. Summers was quoted on Bloomberg as saying, “This is the least responsible macroeconomic fiscal policy we’ve practiced in 40 years.”
As Munger and Buffett said:
Munger: “It’s not at all clear whether Larry is right or wrong.”
Buffett: “But he’s a smart man.”
Munger: “He’s a clever man. He’s brave to bring it up too. He’s practically the only one who talks like that, which by the way, I admire.”
Buffett: “Yes. It guarantees that he won’t get a position in the administration.”
Munger: “Yeah. Well that’s one of the reasons I admire him. Not that there’s anything wrong with holding a position in administration, but I think that people who tell it the way they think it will , I like it.”
The information contained in this letter reflects the opinions of Smead Capital Management and should not be construed as personalized or individual investment advice and is subject to change. Past performance is no guarantee of future results. Cole Smead, CFA, President and Portfolio Manager, wrote this article. It should not be assumed that investment in the above securities will or will not be profitable. The composition of the portfolio is subject to change at any time and references to specific securities, industries and sectors in this letter are not a recommendation to buy or sell any particular security. Current and future portfolio holdings are subject to risks. In preparing this document, SCM has relied on and assumed the accuracy and completeness of all information available from public sources without independent verification. A list of all recommendations made by Smead Capital Management within the last twelve months is available on request.
© 2021 Smead Capital Management, Inc. All rights reserved.
This letter and others are available at www.smeadcap.com.
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