There are few greater pleasures than sitting under a bright red and white umbrella, out of the California sun, eating a $1.50 Costco hotdog. That dollar fifty buys you the hotdog and the sauerkraut and the fountain drink.
Making the hotdog happen for one dollar and fifty cents has taken thirty years of effort and says a great deal about inflation. The price seems outdated because it has not changed since 1985. In the meantime, American consumer prices have doubled and wages have tripled. To keep the price constant while breaking even, Costco has had to add complexity and capital investment. In the 1980’s and 1990’s, the company countered rising commodity prices by using its growing scale to renegotiate meat costs with suppliers. By the 2000’s, Costco vertically integrated to strip costs out of the supply chain and to leverage its position as a buyer of nearly 90 million pounds of hotdog meat. This meant that Costco had to take on equipment as well as personnel to make the hotdogs internally. Over time, the company also had to develop a brand to gain more bargaining power over suppliers. This recently came in handy as the company fired Coca-Cola to keep costs down – without seeing a slowdown in sales.
Costco’s experience with hotdogs is true for most endeavors in a competitive, inflationary society – keeping the price/quantity relationship the same for customers and investors requires a constant effort. Consider the investments that already enormous, already established companies such as Target or Inditex (Zara) have had to make since 2004 just to survive. Think about how much the Target brand and store footprint have evolved over the past decade. All of that effort, all of that successful execution – only to have the privilege of earning the same return on capital a decade later and of avoiding the fate of JC Penney.* So whether your business is making hotdogs, running a social media platform investing $19 billion in mobile apps to stay relevant, or running an investment firm trying to deliver the same alpha as a decade ago – the physics of business require more complexity and capital expenditures in order to credibly deliver the same output over time.
But what happens in a deflationary society? Suddenly, it becomes easier for Costco to make a hotdog meal for $1.50. As time passes, the company needs to invest less capital, add less complexity and fewer personnel in order to deliver value for the same price. Imagine how deflation would change successful industries such as the railroads. There would be modestly less demand for the goods running on the railroads and the price of those goods would be declining. As a result, the railroads would be able to charge less and less for their services and earn a diminishing return on capital invested. The same principle applies to real estate and other capital-intensive industries. The borrow-cheap-and-buy-long-duration-businesses-that-thrive-off-of-inflation investment strategy employed by many value investors like Berkshire Hathaway would no longer be viable.
I am not advocating for wholesale positioning for deflation. It is merely worth considering that the textbook for operating in a deflationary environment is bottoms-up, entirely different from what generations of investors have seen to date. Because of the way our economy is currently being managed – as deflation comes – its effects will be unevenly distributed (see Ripples). Investors in the energy sector have recently gotten a first taste of this. The energy and food industries will be of interest in understanding deflation because of their capital intensity and the role they play in the consumption basket.
So where would one want to move capital to take advantage of a deflationary environment? Treasury yields are already low, so meaningful absolute returns have been wrung out already. Stocks, real estate and commodities would gradually lose value. Opportunities for earning real, absolute returns become very scarce. Perhaps the only place to allocate capital in this environment would be to organizations that make returns from the differences in value between assets rather than simply riding asset inflation. In plain English, an alpha-generating hedge fund. After five years of getting kicked by the media and with pension funds divesting, perhaps it is time for hedge funds to have their day in the sun again.
*Target has grown a lot larger since 2004 making it difficult to earn the same return on capital because of a larger capital base rather than simply inflation/competition. However, one could argue that the company had to grow larger in order to access efficiencies of scale to compete and survive.
THIS ARTICLE REPRESENTS THE VIEWS OF BISHOP ROCK CAPITAL, L.P. AND SHOULD NOT BE CONSIDERED A RECOMMENDATION TO PURCHASE OR SELL A PARTICULAR SECURITY.