We Study Billionaires - The Investor’s Podcast Network - TIP501: Investing During an Inflationary Environment

Starting point is 00:00:00 You're listening to TIP. Hey everyone, welcome to the Investors podcast. I'm your host, Clay Fink, and today's episode is a really important one because it covers what you need to know to protect yourself against inflation as an investor. After my research on Ray Dalio's archetypal big debt cycle, I suspect that we may see more inflation for the years ahead, as our governments deal with its massive debt problem. The overall system weatheres through this type of unique, environment. During this episode, I discuss a number of different asset classes that can protect us

Starting point is 00:00:36 from inflation. Warren Buffett prefers to hedge inflation with quality businesses, so at the end of the episode, I discuss Adobe and Microsoft and do an intrinsic value calculation and why I believe they fit Buffett's definition of a long-term inflation hedge. For the other asset classes, I pulled some of my research from Lynn Alden's work, who as always is pure signal, in a very noisy world. Without further delay, let's dive right in. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. During today's episode, I wanted to do some research and cover how investors can

Starting point is 00:01:33 protect themselves during inflationary, as well as stagflationary market environments. A stackflationary environment is the double-edged sword of having high levels of inflation and low economic growth, which is what we've seen as of late. Just looking at this year, for example, CPI inflation in the U.S. started at 7.5% in January 2022 and is now at 8.2% for the official number for September 2022. Meanwhile, GDP in the third quarter of 2022 only increased by 2.6%. So we have this environment where central banks globally provided massive levels of stimulus after the COVID pandemic. Once inflation started to show up, the Federal Reserve stated that inflation was transitory.

Starting point is 00:02:22 Then in early 2022, Russia invaded Ukraine, which put even more pressure on inflation, and it seems to be fairly sticky in that it's not coming down at any significant pace, at least currently. Energy prices in Europe in the meantime have absolutely. skyrocketed. Now, in thinking about what causes inflation, we can look at monetary inflation, which essentially means how much has the money supply increased over a certain period of time, or inflation can be caused by an increase in commodity prices, which is a supply and demand dynamic.

Starting point is 00:02:58 So higher levels of money printing may lead to more demand for commodities, which would naturally lead to inflation as well. But the other side of the coin is that a commodity shortage being caused by things like a supply chain issue or the Russia and Ukraine conflict. Today, we're seeing inflation likely because of both issues, I believe. Monetary inflation was running hot in 2020 and 2021. So the U.S. government ran these large fiscal deficits, people received their stimulus checks, their PPP loans and such.

Starting point is 00:03:30 Additionally, the artificially low interest rates encourage people to borrow money, whether that be to buy a house, do renovations, purchase more goods in the economy, etc. This led to high CPI inflation later in the year in 2021, but we also had the supply chain impacts from the COVID lockdowns, as well as the Russia-Ukraine conflict. So I see both a supply and a demand issue here with the monetary inflation and then the supply chain impacts from the lockdowns as well as the Russia-Ukraine conflict. Lynn Alden has said that inflation is largely driven by the prices of commodities, which makes complete sense. Much of the cost to get food in the grocery store is the energy or gas required to ship it from point A to point B. Same thing with all

Starting point is 00:04:17 of our day-to-day consumable items that we use every single day. So energy and commodities are a big factor for whether we have high or low inflation. So summarizing a bit, CPI inflation isn't just a monetary phenomenon of the central banks printing more and more money, but money printing certainly does have a correlation with CPI inflation. The COVID crisis and the lockdowns were very deflationary, so there was a massive fiscal response and fiscal spending, and then there was a delay in that monetary inflation actually leading to the CPI inflation statistics. Now, to get an idea of how we should invest during inflationary time periods, we can look back at what has happened in past inflationary time periods to try and get a good idea of,

Starting point is 00:05:04 how we should approach it. The two decades that come to mind are the 1940s and the 1970s. When I look back at a period like the 1940s, I see there were high levels of monetary inflation, as well as high levels of CPI inflation. A similar scenario occurred in the 1970s as well. In January of 2021, the rate of monetary expansion of the USM2 money supply was up over 26% year over year, and that's when the the rate of growth of the M2 money supply had peaked. Now, it's hard for me to believe that the government and the central banks will be able to inject this much capital into the economy and suddenly just go back to a normalized environment. Looking back at the 40s and the 70s, there were waves of printing performed every two or three

Starting point is 00:05:53 years, which likely was a big factor in the inflationary spikes as well. It's really important to understand that inflation was up and down throughout the 40s, the 40s and the 70s as some years experienced high inflation, while other years were relatively moderate or low inflation. Looking at the 70s, for example, the decades started with inflation around 6%, then inflation dropped to around 3% in 1972, and then peaked up at 12% in 1974, and dropped back down to 5% in 76, and ran back to over 14% by 1980. So you really have these inflationary spikes every two or three years. Zooming back to the 40s, we see a very similar pattern where you had these spikes of inflation every few years. So when these institutions and policymakers

Starting point is 00:06:44 tell us that they're going to crush inflation and we're just never going to see it again, I'm personally a bit skeptical to say the least. Lynn Alden explains that the 1970s inflationary time period was largely driven by demographic forces such as baby boomers entering the workforce and creating that significant demand pressure, as well as a lot of credit growth from these consumers taking on new loans for things such as homes. So the 70s was really a boom from the consumers with the baby boomers entering their workforce. In reviewing Lynn's work, she believes that the best analog for the current period of inflation is the 1940s.

Starting point is 00:07:23 During the 1940s, you had these large fiscal deficits that were monetized by the central bank, so you had a lot of extra money in the overall economy. During the 1940s, as many are aware, this was the World War II period, so the government was spending tremendous amounts of money to try and fund the war. Comparing that to 2020 and 2021, the government was putting out fires in terms of the coronavirus, sending out the PPP loans, the stimulus checks, etc. Additionally, the 1940s was the end of the long-term debt cycle as well, which is what I dove into during my previous episode if you like to learn more about how these

Starting point is 00:08:01 cycles play out. That is episode TIP 498, if you're interested in checking that out. So the debt was much more of a problem during the 40s than the 70s. I believe the debt to GDP during the 70s was only 30%, whereas today we're seeing debt to GDP of over 130%. Next, I wanted to play a clip with Ray Dalio's thoughts on the current market environment and where we stand today? Can the Fed effectively reduce demand without breaking the back of the economy? Okay. And rather than just jumping to the answer, I always like to deal with the mechanics

Starting point is 00:08:37 of the mind the answer, you know? And I think the answer is no, but here's the reason why. When there's a lot of debt, one man's debts or another man's financial assets. And they have to balance both of those things. And so they will not be able to, raise interest rates to a high enough level to adequately provide a real return to investors. So if you think about the rise in rates, and we say 3% is an interest rate, or even 4% in the interest rate, that is not going to be an amount of money that's adequate to compensate for the inflation rate. And we're in a paradigm shift, I think. A paradigm is, you know, something happens for 10 years, an environment for 10 years, and at the end of that 10 years,

Starting point is 00:09:29 people believe everything that happened in the prior 10 years, and then they get a surprise. And then they start to change. And something like, for example, do I lead cash is a safe investment or bonds are a safe investment after a 40-year bull market and those types of things. That begins to shift as they start to think, am I getting a real return? So there's going to be a supply demand balance. Most importantly, the Federal Reserve is going to sell, individuals are selling, foreigners are selling, and the U.S. government is selling because it has to fund its deficit.

Starting point is 00:10:04 So there's going to be a supply demand problem that means that it produces a squeeze because so much money was put out at such cheap rates and so much financing was taken that it'll be difficult to achieve that balance. So I remember when you would tell us that cash is trash. Yeah. Is cash still trash? Of course cash is still trash. I'm asking you, do you know how fast you're losing buying power in cash?

Starting point is 00:10:32 I feel that in terms of inflation every day. However, I'm also, for those who own equities out there, they're feeling it even worse. Well, it depends what, okay. The question is what's going to get you a real return, right? And so we've shifted it into an environment where assets that do well, like in the 70s, are in those types of things. Real assets, real return assets in its various ways are the best investments. I think the world is long. Here's the dynamic. I think that's a problem. Everybody's long, equities and so on. And everybody wants everything to go up. And the Federal Reserve wants

Starting point is 00:11:10 everything to go up. So what they do is they give you money and credit, lots of money and credit that helps hyping it. And when the more they hype it, the more it becomes somebody else's financial asset they're holding. And so the world is holding all these financial assets and so on. You can't have that. So you're going to have an environment, I think, of negative real returns. And so as you think about how do you diversify your portfolio or even be short those things, everything can't go up all the time. That system won't work that way. All right. So my big takeaways here, interest rates on U.S. Treasuries are expected to be negative in real terms over the next decade, meaning that anyone that purchases a U.S. Treasury today that yields, say, 4% will lose buying power

Starting point is 00:11:57 because the inflation rate may end up being higher than 4%. So the real rate of return on bonds is expected to be negative, at least from Dalia's point of view, and as well from the perspective of many other investors such as Lynn Alden and Preston Pish. Second, cash is still trash over the long run because cash will do even worse than bonds because it doesn't, doesn't provide a return for actually holding it. Stocks are a mixed bag, as Dalia would put it. From a high level, many stocks aren't able to keep up with inflation for a number of reasons. First, it's difficult for companies to plan ahead during an inflationary environment.

Starting point is 00:12:36 The revenues are oftentimes increasing with inflation, but they don't know exactly how much their expenses will be increasing over time. So it makes it really difficult to do business during this type of environment. The second reason that stocks may not do so well is because high inflation may lead to higher interest rates, and higher interest rates oftentimes lead to lower stock valuations. During the 1970s, the Dow Jones Industrial Average was essentially flat over the entire decade in nominal terms, meaning that in real terms, the Dow was down after adjusting for inflation. Transitioning to commodities, commodities are by definition increasing in price during inflationary

Starting point is 00:13:18 time periods, commodities that are needed and used in the real economy, and especially commodities that are undersupplied and have been underinvested in. This leads to higher prices, which takes years for the necessary investments to be made to compensate for the under supply of that commodity. While most financial assets have been crushed in 2022, funds like XLE, which is an energy fund, is up 55% year to date through the start of November. However, there are plenty of drawbacks with going long commodities or long commodity companies. First, commodities are very volatile. So when you go long commodities, you have to be willing to weather through that volatility.

Starting point is 00:14:01 Commodities themselves aren't something you want to buy and hold for the long run because they're very cyclical and move in these boom-bust cycles. Once commodity prices increase substantially, then companies are incentivized to heavily invest in increasing the production of said commodity. This leads to an abundance of that commodity and eventually lower prices. So very boom-bust type scenarios for many commodities. Now, commodity-related companies such as the company's Buffett purchase, which is Chevron and Occidental, are potential better long-term holds than the commodities themselves.

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Starting point is 00:18:34 slash WSB. Go to Shopify.com slash WSB. That's Shopify. dot com slash WSB. All right. Back to the show. After tuning into Lynn Alden's episode with Stig Broderson, episode 491,

Starting point is 00:18:52 Lynn is long these types of companies to help protect against inflation. Stig asked Lynn Alden a question about Buffett's purchase in these companies, and I wanted to play her answer here for the audience. Here it is. We follow Warren Buffett and his investments quite closely here on the show. And Buffett recently built a $25 billion position in Chevron, equivalent to an 8%-ish ownership, and almost a 30% stake in Occidental. Buffett also have a lot of warrants there, so that's why I came up with that number.

Starting point is 00:19:24 You only look at common stock, it's 20-ish. What are your thoughts on the two stocks of the current market price? So long-term, I'm bullish on them. Sheffron is one of the more expensive ones, but it's also one of the higher quality safe liquid ones. And so my approach has been more kind of geographic diversification and more different oil types. So I have some of like that kind of company. I also have some of the Canadian companies. I think that there are other ones around the world.

Starting point is 00:19:51 I've also been like some of the pipelines. He also bought, you know, they bought a pipeline from a company, right? So it's about energy producers and infrastructure. I think like any good value investor, and he's, of course, you know, legendary for it. He knows what's cheap and he knows what underinvested in. And it's kind of an anti-bubble in many ways. And so I think he's been smart to get into the energy space. And, you know, obviously with his size of his book, he's going to go for the big liquid, you know, longer duration type of projects. And then also, I mean, he, you know, a couple years ago, he did those

Starting point is 00:20:24 Japanese trading companies. So he put a few billion dollars into those. And, and those are, in many ways, they're commodity-oriented, hard asset, you know, and some of them have energy exposure. So, and if you kind of tally up his overall kind of commodity, energy, you know, even the infrastructure from moving it like pipeline, he's made a pretty big bet on energy. And I think that's smart because, you know, he's obviously, he's got that Apple position. It's very tech-oriented.

Starting point is 00:20:51 He's got the banks. And so, you know, I think he wanted to add to the real asset side of his book and specifically in areas that are underinvested in. So it's kind of, especially when he started doing them, It was less, you know, it's a little bit more contrarian than it was now. And a lot of, you know, sometimes he gets criticized for not being super early. Like when he bought Apple, people were like, Apple, really? It's one of the biggest companies.

Starting point is 00:21:11 It's already done great. And of course, it did amazing after that. So, you know, when he started getting into those oil companies, they already did pretty well. He didn't, like, buy them at the bottom in like March 2020. They were like, you know, isn't that kind of over? And I think we're in the beginning of like a five, 10 year story here for some of these companies and just this sector in general.

Starting point is 00:21:28 And I think I think he sees that and that he sees. He's setting up Berkshire to be well positioned for that. So that's some great information there from Lynn on why we may want to consider energy as a part of our portfolio to try and hedge against inflation. Even though we've already seen a fund like XLE make a significant move to date, it's more of a longer-term play the way she sees it. Related to energy and commodities is monetary commodities. Monetary commodities such as gold and silver tend to do very well during state.

Starting point is 00:22:01 Daxflationary and inflationary environments, but not at the exact moment of high inflation. I believe that the best approach to weather through this sort of environment and protect yourself is to be exposed to a number of different asset classes and to be diversified. Own things like quality equities, quality real estate, some commodity exposure, exposure to monetary assets, as well as a cash position to have just in case the economy really breaks and incredible buying opportunities happen to present themselves. I also wanted to touch on how different types of equities perform during inflationary environments. During a period of low interest rates, cheap and easy money, it's an environment that is primed

Starting point is 00:22:44 for unprofitable, high-flying tech companies to thrive. They're much more speculative and richly valued, but during a stagflationary environment, you'll want to own the higher-quality companies with strong balance sheets, strong free cash flows, strong pricing power so they can continue to increase prices, and companies that are resistant to margins getting squeezed. Drilling down to how value stocks perform relative to growth, Value stock's best performance relative to growth is during inflationary time periods. Broadly speaking, value stocks refer to stocks with average or below average PE ratios, higher dividend yields, with gross stocks being high PE, unprofitable companies that pay no dividends.

Starting point is 00:23:28 Value stock's best performance relative to growth was during the 1940s, the 1970s, and 1980s, as well as the 2000s. One big reason, I believe, for this outperformance is that when inflation shows up, this leads to higher interest rates, and higher interest rates are going to hurt growth stocks more relative to value because most of the projected cash flows of a growth company are further out, say, five or ten years or more. Year to date performance for 2022 is a prime example of the divergence between growth and value. Through the start of November 2022, the 10-year treasury rate increased from 1.6% at the start of the year

Starting point is 00:24:09 up to 4.1%. Meanwhile, the ARC fund, which is more of a hyper-growth type companies, they are down 62% year-to-date. The Russell-1000 Growth Index is down 30% and the Russell-1,000 value. index is down 12%. So, 2022 has followed suit with how we would expect the relative performance of value growth and hypergrowth to be during a time of high inflation and rising interest rates. Related to monetary commodities, whether that be gold or Bitcoin, I'll leave the debate between the two for another day. I think that both of these have a lot of potential asymmetry with them due to sovereign nations potentially accumulating much more of one or both of these. and let me explain why. In a rising rate environment, U.S. treasuries are declining in value,

Starting point is 00:25:00 as we've seen in 2022. Additionally, the coupon payments on those U.S. treasuries are going down as the U.S. dollars are declining in value with inflation. So the values of the U.S. treasuries are in a decline while the Fed performs QT. Plus, if inflation sticks around, these treasuries are not going to hold their buying power as well as they once used to. Thus, I think we could see a significant run in monetary commodities because countries are realizing that they could be sanctioned and not be able to tap into that buying power, such as what happened to Russia. So the counterparty risk is coming to light for these countries, and monetary commodities like

Starting point is 00:25:39 physical gold or Bitcoin held in self-custody are two monetary assets that can't be sanctioned or taken away by another country with a click of a button. Plus, they can't be printed or created out of thin air by any other country. There's this chart I've ran into from gold.org that shows the demand for gold from different entities. And it showed that in Q3 of 2022, there was a record amount of gold purchased by central banks globally. There are a number of reasons why I believe gold specifically is a good inflation hedge. The first being that over a long enough time frame, gold tends to increase in line with the rate of monetary inflation, or at least in line with the increase in the M2 money supply.

Starting point is 00:26:22 There are times when gold is significantly undervalued relative to the money supply, such as during the 2000s, and there are times when it gets a bit ahead of itself, such as around 1980 and 2011. Based on a chart that Len Alden put together in her article titled Four Simple Reasons to Buy Gold, she shows a chart of the price of gold relative to the M2 money supply per capita, and based on that chart, gold is either at its fair value or potentially slightly undervalued if the chart were updated through Q3 of 2022. From this perspective, I think that going long gold doesn't make me particularly extremely bullish on gold. If anything, I simply see gold as a hedge against the continued

Starting point is 00:27:06 debasement of the currency should the money supply continue to expand rapidly over the decade to come. Another reason to own gold that Lynn outlines in our article is the inverse correlation with real interest rates. If you think about it from a sovereign perspective, for example, if inflation is running at 8%, and you could buy a U.S. Treasury for 4%, this gives these sovereign nations an incentive to prefer gold over U.S. treasuries because the real interest rate on U.S. treasuries is a negative 4%. If the real interest rate were negative 8%, then there would be a real interest rate.

Starting point is 00:27:42 be an even greater incentive to own gold. So rather than thinking about gold being a good inflation hedge, it's actually the case that gold tends to do well in an environment of low or negative real interest rates. Inflation ran hot in the 1980s when interest rates were high, but gold actually did really poorly after running up significantly in the 1970s. The big takeaway is that sovereign nations can think of gold as a potential asset relative to U.S. treasuries in relative to cash. So when U.S. treasuries and cash aren't very attractive, then gold may be a better alternative for them. If inflation continues to run hot throughout the 2020s and U.S. Treasury yields stay below, say, 5%, then I would expect gold to outperform many other asset classes.

Starting point is 00:28:32 Another interesting case for gold is how indebted the global economy is. Most countries will not be able to sustain an environment of high interest rates, meaning that I would expect real interest rates for many countries globally to be negative, and the over-indebted countries will likely need to print money to monetize the debt they have and continue to fund their deficits, which means currency devaluation and potentially a much larger demand for gold going forward. Because of the sovereign debt bubble we're seeing, the way that this ends up getting resolved, like we're saying with Japan right now, is that the currency itself is, is the release valve. They have to print the underlying currency to address the debt problem,

Starting point is 00:29:14 meaning that holders of that currency end up getting burned and pay the price of the debt and currency bubble. Zeroing in on the United States, for example, Lynn Alden has the phrase that large fiscal deficits and deficit spending is, quote, baked into the cake. This is due to demographics and entitlement structures with unfunded liability such as Social Security, Medicare, and Medicaid, as well as the ever-increasing interest expense the U.S. has on their government debt. Transitioning to touch on real estate, cash-flowing real estate also tends to do very well during an inflationary time periods for a number of reasons. First off, assuming that you purchase the real estate at a reasonable price, the value of that real estate tends to increase

Starting point is 00:30:00 as the currency is being devalued, and rents are increasing in those units, whether it be for commercial or residential use. Second, if you secure the property with, say, a 3% mortgage, the value of that loan is evaporating in real terms. So holding that debt is very beneficial because as the currency gets devalued, the payments on that loan become easier and easier to make as your mortgage payments are relatively fixed before accounting for increases in insurance and property taxes. So cash flowing real estate purchased at a reasonable price, is another good inflation hedge, and for some listeners of the show that invest in real estate, this is one of the best options because of the cash flow it can generate each month,

Starting point is 00:30:46 so it can be a big winner in a portfolio with or without inflation. I mentioned bonds earlier in how they're poor inflation hedge. Bonds are more of a beneficiary to disinflation rather than inflation, but there are tips which are a much better option for an inflation hedge, which stand for Treasury Inflation Protected Securities. So when it comes to your typical bond, your principal amount is what you put down. That stays the same throughout the period. So if you purchase $10,000 worth of a 10-year U.S. Treasury,

Starting point is 00:31:19 you're going to get paid that $10,000 at the end of 10 years. But for tips, your principal amount adjusts upward with inflation, which makes them a good inflation hedge. Plus, you never get less than your initial principle. you were to see deflation. Additionally, the interest payments on the tips adjust upwards as well. There are no free lunches, of course, so tips do have some drawbacks. The first is that tips tend to have lower yields than your typical bond. Before bringing in the CPI component, the yield on a 10-year tips in 2021 was actually negative 1%. So if CPI inflation ran at 7% over the next decade, then your

Starting point is 00:32:03 total overall return would be 6% if you had bought at that price. The yield on the 10-year tips today is around 1.4%. So today the price is offering a premium above the CPI inflation rate. So essentially, tips will outperform U.S. Treasuries when inflation is higher than expected, and they will underperform U.S. Treasuries when inflation is lower than what's expected by the market at the time of the purchase. Additionally, it's important to understand that tips only adjusts to CPI inflation, which we know isn't the true accurate measure of the increase in the prices of goods and services for most people. So if your expenses go up by 12%, but the inflation statistic is 8%, then you aren't going to get the full inflation protection with tips. Nevertheless,

Starting point is 00:32:51 I do see tips as a potential option, especially for those that are looking for more of a consistent and stable stream of cash flows that offer some protection against inflation. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. Vanta automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform.

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Starting point is 00:36:06 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income funds prospectus at fundrise.com slash income. This is a paid advertisement. All right. Back to the show. Warren Buffett was also asked how he recommends hedging against inflation during the 2022 Berkshire Hathaway shareholders meeting. I attended that meeting in Omaha. He said that the best hedge against inflation is to invest in yourself.

Starting point is 00:36:39 If you become really good at something, then that gives you pricing power in demanding a rate that compensates for the service you provide. There will always be demand for someone who is really good at what they do. So if you really want to put yourself in a position to benefit a rate, from inflation, first and foremost, you should develop yourself through reading books, listening to great podcasts, and honing your skill sets. You look at some of the wealthiest people in the world or people you really look up to. It's very likely that they heavily bet on themselves and offered something of value to the marketplace.

Starting point is 00:37:14 For this podcast, for example, I went through a ton of Lynn Alden's writings and interviews. It's very clear that she is just a learning machine and just absorb some of the podcast. so much information from a variety of sources. Thus, she's able to give financial and investing advice to her clients that is extremely valuable to them. Buffett is also someone who spends the majority of his day reading, and he's worth $100 billion. To add to that, this concept also reminds me of the Pareto principle and how that can apply to the income someone makes. For example, the best of the best in whatever field you work in likely makes significantly more than the person who is just slightly above average. So the people that are really good at what they do

Starting point is 00:37:59 earn outsized returns on their time. So maybe think about ways you can take that additional step or go the extra mile in your role that will pay off for the many years ahead. I also found this clip from 2004 of Buffett describing how to invest during an inflationary time period. And he also said then that the best investment you can make is in yourself. Additionally, he talked about the types of businesses that are able to weather through inflation the best. First, you want a company with pricing power for a company that's able to increase prices at the rate of inflation at least. Second, you want a company that doesn't have to make a lot of capital investments that are required to help fuel the growth of the company. Buffett has stated that Apple is a fantastic business

Starting point is 00:38:44 because they don't have to make near the capital investments that a company like Berkshire has to make to achieve similar levels of growth. Companies that are capital-intensive are most impacted by inflation because their costs rise significantly and their margins get squeezed if they can't pass those costs along to the customers. Buffett referred to inflation as a corporate tapeworm that eats away at a business, and the more capital-intensive the business is, the larger the tapeworm that is eating away at the profits. Now, most members of the audience aren't going to all of a sudden allocate a bunch of their portfolio to gold or commodities, as most are value investors and follow the Warren Buffett School of Thought of owning productive businesses with pricing power that aren't capital intensive. In thinking

Starting point is 00:39:31 about companies that fit this description, I can't help but think of Adobe. Special shout out to my friend Thomas Truaw at the Steady Compounding Blog. He put together some research on Adobe and Microsoft that I thought was really helpful and I'm going to be touching on today. Adobe specifically has strong in growing free cash flows. From what I can see, they have very strong pricing power, and they are not a capital-intensive business at all. They've built out most of their products, so when inflation hits, they aren't affected nearly as much as other businesses because most of their expenses related to their products have already been incurred. They do put together new product upgrades in which they will be affected to some degree due to higher wages, but for the

Starting point is 00:40:17 most part, inflation does not affect Adobe near as much as a capital-intensive business, as most of the revenue that Adobe receives flows down to their bottom line. So I'd like to do some analysis on Adobe as their stock, like many others, has been getting clobbered in 2022. In November of 2021, the shares hit nearly $690 per share, and during November of 2020, It's trading at under $290 per share. According to our TIP finance tool, the PE is just under 30, and the price to free cash flow is just under 20. This seems pretty reasonable at the surface for a company that has grown their free cash flows per share by over 6x since 2012.

Starting point is 00:41:02 According to the company's website, about 90% of creative professionals use Adobe Workshop, which says a lot about the value they're providing to customers. Adobe is a very asset-light business. Their gross margins are a strong indication of that, as their gross margins for the trailing 12 months is 86%. Operating margins are 35%. Plus, the company has a lot of recurring revenues, which is a fantastic business model, as you don't have to continually sell to new customers year after year. I had the opportunity to chat a little bit about Adobe on the Millennial Investing Show with Adam Ziesel, and he is also a fan of Adobe stock. The management's top-notch. They have a moat that is as strong as any other tech company out there due to the tremendous

Starting point is 00:41:49 network effects that are in place because people doing business with each other want to be on that same platform. They have that strong brand that everybody knows about and is at least aware of as well. Now, in 2011, Adobe made a key transition from being just a company that sold their products and continually upgraded them to incentivize people to buy their products again and again, and they transitioned to the SaaS model of locking customers in at a monthly or annual rate. Also, through the subscription model, they were able to continually roll out upgrades quicker rather than delaying the upgrades for the big 18-month cycle they previously used.

Starting point is 00:42:29 Plus, the subscription model led to higher lifetime revenues from customers. The steady compounding blog stated in an article covering Adobe, recurring revenue is the mother of value creation, and quote, in business, the key to success is reducing friction points. Amazon made a killing out of reducing friction with its one-click purchase in fast delivery. For Adobe, inputting the credit card wants and enjoying the service for as long as you need is as frictionless as it gets, end quote. Their core suite of products under their digital media segment is their Adobe Creative Cloud product, which includes a suite of apps including Photoshop, Illustrator, Acrobat Pro, and over 20 others.

Starting point is 00:43:12 The world is clearly going digital, and Adobe provides so much of the foundation for businesses that need to operate in a digital world. Revenues have grown at over 20% per year since 2016. Their return on capital is nearly 25% per year over the past five years. And additionally, they have a bulletproof balance sheet with very little long-term debt. And this is before considering their purchase of Figma, which I'll be getting to here shortly. They're starting to buy back more shares as the management approved a plan to repurchase $15 billion worth of shares through 2024, which is really good to see. they look to still have over $8 billion to deploy for share repurchases over the next couple of years. They are also a huge beneficiary of operating leverage in economies of scale,

Starting point is 00:44:02 as their operating margins have increased from 26% in 2016 to 37% in 2021, so their revenues continue to increase faster than their expenses. Now, Adobe stock got absolutely hammered on the announcement that they were purchasing Figma for 2026. billion. Figma is a web-based tool used for graphic design, so the acquisition of Figma does help Adobe continue to expand their moat as they're reaching new customers in different ways that they might not have already had a touch point with. Figma also is growing their top line at a spectacular 100% rate in 2022, with an estimated top line revenue of over 400 million, and their net dollar retention rate is over 150%.

Starting point is 00:44:49 Their gross margin is 90% as well, so although Adobe paid a hefty price for Figma, it should help fuel Adobe's continued growth into the future. And this will impact their balance sheet as the deal was funded with half stock dilution and half cash. Turning to their valuation, looking at historical multiples, I see that their EV to EBIT is below 17. This multiple was around 24 and a half around the March 2020 bottom, and their EV to EBIT has not been this low at any point over the past decade. Their free cash flow yield is 5.3%, which seems

Starting point is 00:45:26 quite high for how fast they're growing. It seems to me like the overall market is taking the Figma acquisition as a sign that the company doesn't have much growth potential left internally. Turning to an intrinsic value calculation for Adobe, their free cash flows per share grew at a kegger of 29% over the past five years, which is just incredible. 2020, it grew at 33%. 2020, it grew at 30%. For Q3 of 2022, their business is slowing down a bit as their revenues grew by 13% per year, which is a bit of a slowdown over previous years. I'm going to use a 10% growth rate on the free cash flows for years 1 through 5, and 8% growth rate of the free cash flows from years 6 through 10, 5% from years 11 through 20, and 3% for years 20 plus. For 2020,

Starting point is 00:46:16 I'm going to be conservative and set the free cash flows equal to the trailing 12 months amount that I see on TIP finance, which is roughly $7.1 billion. Projecting those out and discounting back to today, we get an intrinsic value amount of $156 billion for the company, while the stock here in early November is trading at $133 billion for their market cap. So based on this intrinsic value calculation, the stock is trading at around a 15% discount to the intrinsic value. I feel that this projection is fairly conservative relative to how the company has grown in recent years, so I do feel like today's price is a fair value for Adobe. I really

Starting point is 00:46:57 like the company. I think it's trading at a fair valuation. However, that doesn't mean that it can't go lower in the short term due to the actions of the Federal Reserve, raising interest rates, and the overall lower liquidity in the markets. In order to ensure that we aren't catching a falling knife here. I personally wouldn't enter a position until I see that the downward trend where the momentum status has flipped green, because there is no telling how low this could go, as it's down 57% just in the past year. Once I see the momentum in our TIP finance tool flip green, then I would be assured that the momentum and the trend behind the stock has switched, and it's a much better time to go along the company and ensure we aren't catching a falling

Starting point is 00:47:38 knife. Our momentum tool on Adobe was green and positive for quite some time as it flipped green around mid-April of 2020 when the stock was around $336 per share. It remained green throughout 2020 and 2021 and then flipped red once the stock started a fall in January of 2022 at around $525 per share. So in theory, if you would have bought this company when the TIP finance momentum tool flipped green in 2020. You would have bought it at around $336 per share and wrote it to over $670 and sold it on the way down when it hit $525 and flipped red. This would give you a total return of just over 56% over a period of under two years, plus you would have avoided the additional 45% drop from that point in time. Next, I wanted to do some analysis on another company that

Starting point is 00:48:32 may be a good inflation hedge. Apple is one that comes to mind, which is relatively less capital intensive. I actually did an intrinsic value analysis on Apple on episode 489, if you're interested in checking that out. But in today's episode, I wanted to talk more about Microsoft. Microsoft stock peaked out at around $340 per share. And here in November 2020, they're trading at roughly $215 per share in a market cap of $1.6 trillion. The company really had lackluster performance under the leadership of CEO Steve Balmer from 2000 to 2015, but they've performed exceptionally well since Satya Nadella took the reins as a CEO of the company in 2015. Microsoft's business is divided into three segments. One, productivity and business process.

Starting point is 00:49:25 2, Intelligent Cloud, and 3, Personal Computing. The Productivity and Business Processes segment includes Microsoft Office, which most people are familiar with and use quite often, whether that be Excel, Word, SharePoint, Teams, or a number of others. This segment also includes LinkedIn in the Dynamic Business Solutions, and this segment produced $63 billion in revenue in fiscal year 2022. Their Intelligent Cloud segment consists of Microsoft's public, private and hybrid server products, and their cloud services, which is their fastest growing segment.

Starting point is 00:50:01 Their revenue from their cloud tripled from $25 billion in 2016 to $75 billion for fiscal year 2022. Their cloud business specifically is known as Azure, and this has been a big driver for the company's continued growth. During Q1 for fiscal year 2023, their overall cloud revenues increased by 31% year-over-year, and it has a run rate of over $100 billion. Then they have their personal computing segment, which includes things like their gaming products and their hardware sales. According to Steady Compoundings Blog, the four parts of the personal computing business includes, first, Windows, which is their operating system purchased by original

Starting point is 00:50:43 equipment manufacturers. Second, devices, this includes Surface, which is an iPad copycat, and their PC accessories. Third is gaming, which is their Xbox Game Studios and Activision Blizzard. Fourth is search advertising, and believe it or not, they do have revenue coming in from Bing and Microsoft advertising. This segment produced $59 billion in revenue for fiscal year 2022. One new source of revenue for Microsoft is their advertising business.

Starting point is 00:51:12 Their ad revenue surpassed $10 billion for 2022, which came from LinkedIn, Microsoft Start, which is a news feed, and Microsoft Edge, which is a web browser. Ever since Satya Nadella took over as CEO of Microsoft, he has put a lot of focus on driving the growth of cloud, as this segment grew from 27% of revenue in 2016 to 38% of revenue in 2022. Despite the larger revenue base, growth rates have went up to over 30% and Satya reaffirmed during the Q3-2020 earnings call that they are still in the early inning. and growth rates are likely to hold up, as he stated, quote, digital adoption curves aren't slowing down.

Starting point is 00:51:55 In fact, they're accelerating, and it's just the beginning. Digital technology will be the foundation for resilience and growth over the next decade, and we are innovating and building the cloud stack to accelerate the digital capabilities of every organization on the planet, end quote. Additionally, Microsoft's share of the cloud industry has increased from 10% to 20%. Their operating margins have improved significantly over the past few years, as their operating margins increased from 30% in 2016 to 42% in 2022. Thomas's blog, Steady Compounding, outlined three reasons why Microsoft's moat is so strong. The first being the high switching costs.

Starting point is 00:52:39 Microsoft's products are essential to the companies they service, whether it be Microsoft Office or their cloud services, and it can be costly and time-intensive. for them to switch to a different company other than Microsoft. Second, they are a beneficiary of network effects through the likes of LinkedIn and GitHub. LinkedIn has 830 million members and GitHub has 73 million. Each user that joins the platform and is active makes the platforms more valuable for all other users and increases the strength of those platforms. LinkedIn has made up a ton of ground over the past few years.

Starting point is 00:53:17 In fiscal year 2013, revenue was under $1 billion. Today, LinkedIn's revenues are nearly $14 billion. This is up 30% over the last year alone. Third is how Microsoft's products are distributed. Many computers that are sold today already have Microsoft's products pre-installed into them. This reduces the friction to acquire new customers. It makes it extremely difficult for other companies to even compete. Of course, because of the strength of the moat for Microsoft, they have really strong pricing power,

Starting point is 00:53:51 and this makes them a great inflation hedge since they aren't super capital intensive. The biggest risks that I see with a company like Microsoft is the antitrust issues. I think eventually they may get to a point where they get so big and so dominant that the government might step in and break up their business or prevent them from making particular acquisitions. This doesn't concern me too much, but nonetheless, I think the risk is still there. In terms of valuation, I pulled up the EV to EBIT just to get an idea of where the multiple stands today relative to historical standards. From 2018 through 2019, this metric ranged from 18 to 21.

Starting point is 00:54:32 In 2020 and 2021, this got elevated, eventually hitting 30. And now in early November 2022, we are at around 17. So this multiple looks pretty good as the macro environment has contracted, bringing the price of the stock down. Running a discounted cash flow analysis, I took their free cash flows for the trailing 12 months and set that equal to what we would expect for year one. Then I ran the growth out at 12% over the first five years, 10% for year 6 through 10, 6% for years 11 through 20, and 3% for years 20 plus. At the time of this recording, Microsoft trades at around 2%.

Starting point is 00:55:11 $215 per share and a $1.63 trillion market cap. The intrinsic value I came up with at a 10% discount rate is $1.54 trillion, which is a 5% discount to the current price. So given these free cash flow projections, I would expect Microsoft's stock to grow conservatively at around 10% per year, if purchase at today's price. In the end, it is the long-term business results that will drive the ultimate performance of the stock, which I expect to be really good given all the tailwinds they have behind their back and with the management team they have put in place today.

Starting point is 00:55:49 Turning to the momentum chart showing up on our TIP finance tool, the momentum on Microsoft flipped green around April 21st of 2020. It was around $160 per share then. Then it flipped red almost exactly two years later in April 2022 at around $280 per share. The momentum did flip back green this year in August and September, but the stock traded down a bit and it flipped back to red from the end of September to today. I've been compiling a short list of companies I would like to essentially buy and hold forever, and Microsoft is on that list because I just see so many secular tailwinds propelling the company's future growth. At the time of this recording, I don't own any shares of Microsoft or Adobe, but would like to initiate a position once the momentum flips green

Starting point is 00:56:38 and the macro landscape improves in my view. All right, that is all I have for today's episode. I really hope you enjoyed this episode and found value in it. Inflation is a topic I think a lot about in terms of constructing my portfolio and how I can be best positioned to weather through the inflationary storm, which I personally expect may potentially be a recurring theme over the next decade or so. All right, with that, I'll see you again next week. Thanks for tuning in.

Starting point is 00:57:07 Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional, this show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

Starting point is 00:57:37 Thank you.

We Study Billionaires - The Investor’s Podcast Network - TIP501: Investing During an Inflationary Environment

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