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. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory, and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.
Annual Report, 1981
That combination-the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings)-can be thought of as an 'investor's misery index'. When this index exceeds the rate of return earned on equity by the business, the investor's purchasing power, i.e., real capital shrinks even though he consumes nothing at all actually. We have no corporate solution to this kind of a problem; high inflation rates will not help us earn higher rates of return on equity.
Annual Report, 1979
And then came along a 1924 book-slim and initially unheralded but destined to move markets as never before-written by a man named Edgar Lawrence Smith. The book, called Common Stocks as Long Term Investments, chronicled a study Smith had done of security price movements in the 56 years ended in 1922. Smith had started off his study with a hypothesis: Stocks would do better in times of inflation, and bonds would do better in times of deflation. It was a perfectly reasonable hypothesis. But consider the first words in the book: "These studies are the record of a failure-the failure of facts to sustain a preconceived theory.
An irony of inflation-induced financial requirements is that highly profitable companies-generally the best credits-require relatively little debt capital.
But the laggards in profitability can never get enough. Lenders understand this problem much better than they did a decade ago-and are correspondingly less willing to let capital hungry, low-profitability enterprises leverage themselves to the sky.