In an inflationary environment, capital-light companies are more likely to survive (or even prosper).
Capital-intensive companies will be most affected by cost increases and will see their margins squeezed if they cannot pass along the cost increases to their customers. As inflation rages on, investors should protect their portfolio by owning companies that are inflation-resistant.
Let’s dive in.
All businesses consume capital (to varying degrees)
Capital is needed by businesses to run their operations, and the capital is invested in assets that create products or services that generate sales.
Take the example of a typical lemonade stand business. In order to generate sales, the business must invest capital in purchasing a juicer and tables (fixed assets), lemons and ice (inventory), and receivables (if they allow credit).
A lemonade business that generates an 8% return on capital leaves the owner with the following choices:
(1) It can be reinvested back into the business to grow unit sales, or
(2) Taking the profits out of the business for his own consumption while still maintaining unit sales at the same level.
Imagine if inflation came in at 8%
Our 8% returns will be clawed away by inflation.
Your fixed assets, inventory, and receivables, which are required to generate the same unit of sales, rise by 8%.
In other words, you will see unit sales decline if you do not reinvest your earnings into the business to keep it running.
As Buffett wrote, “For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism.”
Inflation is like a tapeworm eating away at a business profits. And the more capital intensive the business, the larger the tapeworm.
Capital-light companies stand a better chance against inflation
Due to their intangible assets, companies like See’s Candies or Google consume very little capital.
See’s Candies is able to charge a premium price not because they use higher quality sugar, milk, and butter (although they do), but because of their superior brand.
And unlike tangible assets, inflation has no power over See’s Candies’ intangible asset: its brand!
In fact, See’s Candies is likely to raise prices during an inflationary environment and earn a fatter profit margin.
Google sells advertising space. Google keeps most of its revenue as profits when a business advertises on the Google Search Engine. There is minimal incremental cost associated with every new customer.
As Google’s value proposition is intangible — its brand, traffic, and database — it is less affected by inflation than other companies that rely on tangible assets to generate sales.
Not all companies are affected the same by inflation
Own capital-light companies since inflation affects them much less. For capital-intensive companies, favor those that raise prices faster than inflation or are at least able to pass on price increases to consumers.