A: Yes, especially when purchased at bargain prices.
Sir John Templeton’s first rule in his 16 Rules for Investment Success is to “Invest for maximum total real return.” In other words, an investor’s goal should be to maximize their invested dollars after taxes and inflation. We frequently encounter taxes of all kinds, but inflation tends to be ignored. To build real wealth, an investor must earn returns that outpace inflation and I believe that investing in quality businesses at a discount to their intrinsic value is vital to accomplishing this objective.
Inflation is simply the increase in prices one pays for goods and services over time. It is best understood in the context of products or services that have endured and maintained their primary use. For example, in 1986 a Big Mac from a U.S.-based McDonalds was, on average, $1.60 and at the start of 2015 it was $4.79. This is an average annual increase of 3.99 percent.
Inflation has serious implications for investment returns and it is imperative to understand the difference between nominal and real returns. Nominal returns are investment performance without considering inflation. Comparatively, real returns factor inflation into the equation and indicate how much your purchasing power has actually increased. Since one day you hope to spend what you have invested, real returns should be your focus.
This can be illustrated with a hypothetical example. If an investor buys a stock at $100 and at the end of the year it rises to $110 and inflation is 2 percent, the investor’s nominal return is 10 percent and real return equals 8percent (10 percent minus 2 percent). In terms of purchasing power if at the start of the same year a soda costs $1.00, at year-end it will increase to $1.02 with inflation. As a result, although our hypothetical investor has 10 more dollars he/she cannot buy 10 more sodas. Consequently, our investor’s purchasing power grew slower than their investment account. This is why inflation matters.
Inflation in the U.S. was a major drag in the 1970s. Although investors in long-term corporate bonds averaged nominal returns of 6.2 percent, inflation was at very high levels averaging 7.4 percent. At first glance 6.2 percent per year seems like a satisfactory return on bonds; however, when inflation is factored into the equation an investor’s purchasing power was actually weaker at the end of the decade compared to the beginning.
I believe that investing in companies that can grow faster than inflation is the best way to preserve purchasing power and grow wealth over the long term. To support this theory, I analyzed five-year rolling returns of selected equities since 1900. The research supported my thesis that equities have definitely been useful in building real wealth. In fact, the five-year compound returns exceeded inflation and provided positive real returns 74 percent of the time.
Furthermore, it is my conviction that investing in businesses at the right price yields even better real returns. Over this same time period, I analyzed the impact of purchasing stocks when they were cheapest as judged by the price-to-earnings ratio. I found that the time periods when stocks were selling for a bargain yielded an average annual real return 6.87 percent greater than times when stocks were expensive. In the context of total returns, this means that patient investors who waited for discounts would have had about 40 percent more real wealth than investors who purchased equities when they were most expensive at the end of five years.
There is no doubt that inflation can erode the purchasing power of accumulated wealth. My research has shown that purchasing equities at bargain prices has proven to be an effective strategy for outpacing inflation. I seek to invest in small- to mid-sized companies at a discount to my estimate of their intrinsic value in order to protect and increase real wealth.
Fenimore Asset Management is an independent investment advisory firm located in Cobleskill, NY since 1974. Fenimore’s affiliates are the Fenimore Private Client Group & FAM Funds – offering separately managed accounts and mutual funds. In-depth research. Insightful investing.
