Sunday, August 15, 2010

Low Cost Producers and a Deflationary Environment

Deflation has been receiving much attention as inflation is running right about at zero, so I was theorizing what kind of of firm would do well in a deflationary environment. On the surface it would seem businesses which produce at the lowest possible cost. Deflation is merely the reduction in the price of goods most often because of diminished demand. Firms like Wal-Mart which prices below competition because of their low costs could surely handle a decrease in prices. Their margins may narrow, but they won't be bleeding red ink like their competition which will not be able to price below their costs.

Warren Buffett has ramped up purchases in Wal-Mart and Wells Fargo, both low cost producers with Wells having a low cost of obtaining credit. Though I don't think Buffett is buying on the premise of deflation, contrarily he has grown exceptionally concerned about inflation. Bloomberg had reported he was reducing the duration of his bonds. The longer the duration of the bond, the more exposed you are to rises in interest rates/inflation as rises in rates leads to a decline in the value of bonds. So his intent to purchase Wal-Mart was more likely because of price. He has held the stock for many years and it is arguably the cheapest its been in the past 10-15 years.

In any case, macroeconomic fundamentals are very difficult to predict. I think Buffett and many other investors would agree, that it is exceptionally difficult to accurately predict macro environments. Case in point would be the mid 2000's. Many were calling (James Grant of Grant's Interest Rate Observer for one) for higher interest rates and a depreciated U.S. dollar. What happened? Post 2008 the dollar appreciates as investors "flee to safety" of the dollar and interest rates plummet to historical levels. Long-term fundamentals probably to favor those projected trends, but predicting short-term values are likely to be exceptionally difficult. So investing should be limited largely to firm and industry specific data. There is plenty to know about any given business, and worrying about the economy just detracts from where your attention should be.

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