“But it’s not a price sensitive economy at all right now. And I don’t know exactly how it shows up in different price indexes, but there’s more inflation, a lot more inflation than people. would have anticipated. just six months ago or so. ”
Warren Buffett (Trades, portfolio)
“Yeah. And there’s a very smart man who thinks it’s dangerous and it’s just the beginning.”
Charlie munger (Trades, portfolio)
To say that we were surprised by some of the discussion at Berkshire Hathaway (BRK.A, Financial)(BRK.B, The annual financial meeting would be an understatement. The conversation
Warren Buffett (Trades, portfolio) and
Charlie munger (Trades, Portfolio) looked at inflation was perhaps the most interesting. Buffett and Munger have given Larry Summers great credit for his willingness to stand alone on the effects of current fiscal and monetary policy on prices. We thought this was a great time to go over Buffett and Munger’s discussion and see what conclusions we might draw from it.
Buffett responded to a question about the signs of inflation by saying:
“We’re seeing very substantial inflation. It’s very interesting. We are raising the prices. People are raising the prices to us, and it is accepted. Build at home. We have nine home builders in addition to our house operation. Prefabricated, which is the largest in the country. So we build a lot of housing. The costs are just up, up, up. Steel costs, every day, they’re rising. not yet had because the wages UAW signs a three year contract, we have a three year contract, but if you buy steel from General Motors or whatever, you pay more every day. weren’t expecting. “
Greg Abel followed up by saying:
âYeah. Warren, I think you brought it up, when we look at steel prices, lumber prices, any oil input, basically there’s a pressure on those commodities. I think you’ve got it. hit something, Warren, and it’s really going back to raw materials. There is currently a product shortage of certain raw materials. This has an impact on the price and the ability to deliver the final product. But this scarcity factor is also real right now, as our businesses are responding to this challenge. “
In my economics classes at Whitman College, we were taught that money supply multiplied by speed equals price multiplied by output (MV = PY). Much of what has happened since 2009 is an increase in the money supply (M). What has stymied the increase in the money supply has been a slowdown 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 monopoly game, but no longer paying for transit or free parking. The game was not going to speed up just because the bank had more money.
To think about it today, we have to start by saying that the money supply increased by 24% last year. If the speed remains the same as it was before, the prices would increase by this amount. Data argues that the speed has declined further over the past year. We still believe that the Monopoly analogy can teach us more.
The US Federal Reserve increased Monopoly bank money. The federal government is handing out over $ 200 to spend and paying hundreds of dollars for free parking through loans, grants, and stimulus checks. In the context of monopoly, they are willing to pay you money just to be the pawn on the board.
We believe that the invisible hand of Adam Smith (aka the market) is beginning to understand this issue faster than economists. Why, you might ask? Investors and business owners have more incentives than academics from government or educational institutions. Perhaps economists will come back later and explain why. However, it won’t help you with inflation. The worst part about inflation is that you don’t know how bad it is until much later.
Where is the game of Monopoly picking up? It is noticeable in the raw material as Abel mentioned. Lumber, copper, steel and cotton all hit five-year highs. Buffett commented on the accommodation. Housing has a tight supply and therefore exhibits price inelasticity. If the price of inputs increases among our manufacturers (NVR (NVR, Financial), Lennar (LEN, Finance) and DR Horton (DHI, Financial)), they react by increasing the price of the house more than their costs.
The return to the economy has taken investors and economists on the wrong foot. As Buffett said, “this economy right now, 85% of it is going into high gear, and you see some inflation and all of that, it’s reacted in an incredible way.” If we were wrong about the economy’s reaction 12 months ago to today, maybe we don’t know where we are going.
We think housing is probably the most interesting aspect of the inflation issue. It appears we’ve had a tectonic shift in housing since the start of the pandemic and the political response. Millennials love homes, and an act of God has led them to become the new suburban immigrants. Baby boomers love homes and don’t get out of them like previous generations. As a result, the current supply of homes for sale is at a two-month record high. As an example, the chart on the right shows house prices among the construction prices of existing and new homes during the 1970s.
Investors say that as real interest rates rise, housing will suffer. Data from the 1970s support the opposite. As real interest rates rose, housing was shielded from inflationary pressures and left additional compensation for the risks of that era beyond the effects of inflation. In other words, inflation has shown you higher levels of price pressure in other inflationary times, even if affordability is declining rapidly.
We have discussed this within our investment team. We believe the cost of replacing an existing home is rising faster than appraisal reports can track. The replacement cost only increases when inputs increase and finished houses are held up by a lack of skilled labor.
How can this price reaction be so explosive in the short term? Buffett and Abel commented on the prices of the materials. The other element to note is the lack of production capacity. We hear about chip shortages in the news as an example, but there are a myriad of products to look forward to. The bigger they are, the longer you wait. Supply chains are disheveled. There is a quick way to hire and increase production: raise prices.
Another way to think of this story is inflation / labor wages. For the first time since World War II, the government is the main competitor of low-cost workers. We hear from public companies, like Chipotle (CMG, Financial) and the private companies with which we interact with which it is difficult to find workers. Dishwashers are an example in restaurants. Bloomberg reported that prices were going up and incentives were being offered. The reason is that the government is competing for these workers with stimulus checks. You can get paid for doing nothing. Why come in?
It’s kind of like Buffett said on the UAW (United Auto Workers) contract. If housing costs, the cost of a car, and the cost of going out to eat go up, it’s only a matter of time before workers make demands or companies want their business to come back. at full capacity, dispense increases to prevent the need for manpower. Here is an overview of the wait times for ISM equipment and supplies.
It has never been so bad in supply chains since 1987. You might want to buy a product and a company might want to produce it for you, but it will take them longer than in the past. The same commodities produced longer create scarcity. Shortages create pressure on prices. Buffett commented, “Supply chains are all screwed up for all kinds of people, but it’s almost a buying frenzy.”
We’ll end this piece with a tip of the cap to Larry Summers like Buffett and Munger did. Summers was quoted on Bloomberg as saying, “This is the least responsible fiscal macroeconomic policy we have had in the past 40 years. It is fundamentally driven by the intransigence of the Democratic left and intransigence and behavior. completely irresponsible of the whole Republican Party. “
As Munger and Buffett put it:
Munger: “We don’t know at all if Larry is right or wrong.”
Buffett: “He’s a smart man, though.”
Munger: “He’s a smart man. It’s also brave of him to raise him. He’s pretty much the only one who talks that way, which I admire, by the way.”
Buffett: “Yeah. That guarantees he won’t get a job in administration.”
Munger: âYeah. Well that’s one of the reasons I admire him, not that there’s nothing wrong with having a job in administration, but I think people who say it the way they think, I like it. “
The information contained in this letter represents the opinions of Smead Capital Management and should not be interpreted as personalized or individualized 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 investing in the above mentioned 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 do not constitute recommendations to buy or sell any particular security. The current and future holdings of the portfolio are exposed to risk. In preparing this document, SCM has relied on and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management over the past twelve months is available on request.
2021 Smead Capital Management, Inc. All rights reserved.
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