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The

 Intelligent  Investor  
Chapter  2:  The  Investor  and  Inflation  
• Fixed  dollar  investments  such  as  bonds  will  suffer  when  the  cost  of  living  increases,  as  will  
the  value  of  the  dollar    
• Stocks  offer  the  possibility  of  offsetting  the  decline  in  the  dollar’s  purchasing  power  with  
dividend  and  price  appreciation    
• Conventional  wisdom  is  that  during  periods  of  inflation  common  stocks  are  more  desirable  
than  bonds  
• The  intelligent  investor  recognizes  that  operating  on  this  assumption  without  regard  to  
underlying  fundamentals  is  inherently  dangerous    
• In  order  to  make  a  reasonable  estimate  of  how  to  handle  future  inflationary  situations  it  is  
important  to  study  past  periods  of  inflation    
• From  1915-­‐1970  inflation  ran  at  roughly  2.5%  annually  (it  has  been  lower  since)  
• Graham  suggests  3%  as  a  reasonable  estimate  of  inflation  going  forward,  but  admits  this  is  
far  from  certain  
• Rising  inflation  eats  into  the  returns  of  fixed  income  investments  
• Example:  If  a  municipal  bond  has  a  coupon  rate  of  6%  and  inflation  is  running  at  3%  
the  real  return  on  the  bond  is  only  3%  
• When  deciding  which  asset  class,  stocks  or  bonds,  is  more  desirable  in  an  inflationary  period  
the  investor  must  believe  their  total  return  on  common  stocks  will  be  greater  than  the  real  
return  of  a  high  quality  bond  
• From  1915-­‐1970  common  stocks  appreciated  at  4%  annually  with  an  average  dividend  yield  
of  4%  for  a  total  return  of  8%  annually  
• These  returns  are  far  from  certain  going  forward  and  could  vary  significantly  depending  on  
the  valuation  levels  at  which  they  are  purchased    
• Correlation  between  stock  prices  and  increasing  inflation  are  mixed  at  best  
• Increases  in  corporate  earnings  have  been  primarily  due  to  the  large  growth  of  invested  
capital  from  reinvested  profits  
• The  only  way  that  inflation  contributes  to  increased  common  equity  values  is  by  raising  the  
rate  of  earnings  on  capital  investment    
• Two  negative  impacts  of  inflation  on  corporate  earnings  are  increased  wage  rates  exceeding  
gains  in  productivity  and  the  need  for  larger  amounts  of  funds  required  for  capital  
investments  
• Another  negative  effect  of  inflation  is  increased  interest  rates  for  companies  that  are  taking  
on  new  debt  which  eats  into  profits  available  for  equity  owners  
• In  conclusion,  stock  prices  are  likely  to  fluctuate  regardless  of  inflation  
• Using  inflation  as  justification  to  buy  stocks  regardless  of  valuation  is  a  serious  mistake    
• Graham  is  also  suspect  of  using  gold  as  a  store  of  value  during  inflation    
• Real  estate,  another  hedge  against  inflation,  is  also  subject  to  fluctuations  in  value  
• Large  scale  inflation  is  always  a  possibility  and  the  best  way  for  the  investor  to  carry  
insurance  against  it  is  to  split  their  portfolio  between  common  stocks  and  high  quality  bonds  
• Commentary  on  Chapter  2  
• “Americans  are  getting  stronger.    Twenty  years  ago,  it  took  two  people  to  carry  ten  
dollars’  worth  of  groceries.    Today,  a  five-­‐year-­‐old  can  do  it.”  –  Henny  Youngman  
• Inflation  is  often  overlooked  because  of  what  is  known  as  the  “money  illusion”  
§ If  you  receive  a  2%  pay  raise  in  a  year  when  inflation  is  running  at  4%  you  
feel  better  than  if  you  had  a  2%  pay  cut  even  though  both  scenarios  leave  
you  with  the  same  amount  of  purchasing  power  
• Inflation  acts  as  a  stealth  destroyer  of  wealth  
• Here  are  three  examples  of  inflation  wreaking  havoc:  
§ From  1973-­‐1982  the  consumer  price  index  rose  at  a  rate  of  9%  annually  
and  was  accompanied  by  a  stagnant  economy  in  what  was  know  as  
“stagflation”  
§ Since  1960  almost  70%  of  all  market  oriented  countries  have  suffered  at  
least  one  year  with  an  inflation  rate  of  above  25%  which  on  average  
destroyed  53%  of  an  investor’s  purchasing  power  
§ Rising  inflation  gives  countries  with  debt,  like  the  U.S.,  the  ability  to  pay  off  
their  loans  with  a  cheaper  dollar  
• Therefore  eliminating  inflation  is  not  in  the  economic  self  interest  
of  debtor  nations  
§ Stocks  typically  have  not  responded  well  to  either  large  amounts  of  
inflation  or  deflation  
§ Mild  inflation  is  fine  because  companies  can  pass  increased  costs  on  raw  
materials  to  their  customers  
§ High  inflation  forces  customers  to  stop  consuming  because  they  have  less  
purchasing  power  
§ The  author  proposes  two  modern  day  financial  products  that  can  serve  as  a  
hedge  against  inflation  
• REITs,  or  Real  Estate  Investment  Trusts,  are  companies  that  own  
and  collect  rent  from  commercial  real  estate  properties    
• TIPs,  or  Treasury  Inflation-­‐Protected  Securities,  are  U.S.  
government  bonds  that  rise  with  inflation    
o Because  they  are  backed  by  the  U.S.  Treasury  the  risk  of  
default  is  seen  as  very  low