The Insatiability of Inflation.
One of the metrics we look at when we acquire a fractional interest in a company is its Return on Invested Capital (ROIC). Think of it as what management actually returns on the capital employed in a business – a company that consistently returns +15% on capital employed is going to be a very attractive business in the long run. For instance, Hermes returns +16% on capital employed - this is part of why we acquired shares in Hermes for the Elevation Capital Global Shares Fund portfolio, combined with heavily aligned management – the Dumas family owns over 50% of the company, and an unassailable product – if you want to beat inflation, just buy a Birkin! — see chart below.
Source: Baghunter
Inflation’s insatiability, is the subject of the post. As of February 2022, inflation in the US is estimated to be ~7.9%, whilst in France it sits at ~4.5%. In New Zealand, inflation currently sits at ~5.9% (as of March 2022). In fact, all current estimates now peg global inflation to be higher – you don’t need to be an economist to notice just how expensive the costs of basic goods at the supermarket have become in the past year.
No business owner is a fan of inflation. We think of ourselves as business owners, with fractional interests in a variety of businesses. The problem is that inflation eats away at “actual” returns. Warren Buffett calls this a “Misery Index”. For instance, Hermes earns a return on invested capital of +16%. This is wonderful and should be lauded; we wish all businesses could do this. Yet factor in inflation, and the “real return” becomes ~11.5% (it’s even worse if you use US inflation as your yardstick – it reduces what was once a great return to a pallid ~8.1%). In an inflationary environment, even the best businesses look merely good and good businesses look mediocre — and as for average businesses – well – they’re effectively returning nil.
In an inflationary environment the Return on Invested Capital (ROIC) by even the best business becomes poor. Consider the average ROIC for the S&P 500 – it sits around ~9%. Factor in inflation, taxes and other costs associated with transferring earnings to the owner’s pocket and the ROIC is practically zero today.
We do not have a solution to this. Central Banks around the world appear to be reducing their balance sheets, raising interest rates, and taking steps to curb inflation’s insatiable rise. In the meantime, it appears to us that the only solution is to own companies which earn substantially higher returns on capital than their peers and the market at large.
As a thought experiment, let’s take a few of “our” companies, and compare them with their “real” return (ROIC minus inflation): Meta: +20.9%, Estee Lauder: +9.3%, Visa; +7.9%, Autodesk: +6.3%. In non-inflationary environments, of course, these companies generally all have double digit returns on invested capital. Double digit returns act as a growth engine in non-inflationary environments (to paraphrase Charlie Munger: after 20 years, with a double digit ROIC, you’re going to end up with a hell of a result). In inflationary environments they act as a cushion against the perils of a rapidly devaluing money supply. In our view, owning companies which produce an above-average return on invested capital is the only rational insurance on your own capital in an inflationary environment.
Accordingly, in the Elevation Capital Global Shares Fund, we are focused more than ever on acquiring fractional interests in companies which generate an above-average return on invested capital; acquiring them at an attractive price, and letting the businesses do the rest.
