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The Best Type of Investment to Protect Against Inflation

Newswires BBC and Today reported earlier this morning that Singapore has been named as the world’s most expensive city in a list compiled by the Economist Intelligence Unit (EIU). In particular, the BBC did an interview with Toby IIes from the EIU in which he revealed that Singapore was at the 15th spot just five years ago.

For me, this is a clear sign that the insidious wealth-destroyer known as inflation is very much busy at work here.

While I’ve previously pointed out how the stock market as a whole here in Singapore has historically been a good bet to beat inflation, the truth is, there are huge discrepancies in the ability of individual companies to counter the effects of inflation for their owners (i.e. shareholders). And lying at the root of that difference is a company’s need for tangible assets in its business.

Billionaire American investor Warren Buffett sums it up brilliantly in his 1983 Berkshire Hathaway shareholder letter:

Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of intangible assets simply are hurt the least.

And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plans and machinery, or other tangible assets (“In Goods We Trust”). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.”

The basic idea behind all this is that, in contrast to an asset-heavy business, a business that can generate high returns on net tangible assets would require much lesser reinvested capital in periods of high inflation in order to generate growth in profits that can keep pace with the rise in general prices.

And looking at Singapore’s stock market, here are a few examples of businesses with both high and low returns on net tangible assets.

Company

Average return on net tangible assets over past 10 years

Vicom (SGX: V01)

24.4%

ARA Asset Management (SGX: D1R)*

35.7%

Singapore Airlines (SGX: C6L)

8.00%

CapitaLand (SGX: C31)

10.1%

*Figures for ARA are for 2007 to 2013 as the company only got listed on Nov 2007.

Source: S&P Capital IQ

This by no means a recommendation on any of the shares, but we can see that both Vicom and ARA Asset Management have historically had much better returns on net tangible assets as compared to CapitaLand and Singapore Airlines.

If we link that back to Buffett’s admonishment on the better kinds of businesses to own in an inflationary environment, it’s perhaps not a surprise to see Vicom’s shares grow by 589% since the start of 2004, handily outpacing the Straits Times Index’s (SGX: ^STI) gain of only 76% from 1,765 points to 3,110 points currently. In contrast, Singapore Airlines’ shares are still down by 9.3% while CapitaLand’s shares have appreciated in price by 80%, barely edging ahead of the market.

It’s also instructive to compare ARA’s share price performance with the rest of the shares since the start of 2008 (given that the company only got listed on Nov 2007). ARA and Vicom (again) are the clear winners, with their share prices growing by 162% and 222% respectively. Meanwhile, Singapore Airlines, CapitaLand, and the Straits Times Index have lost 41%, 55%, and 11% of their value.

My colleague David Kuo once wrote that[inflation] could last a very long time indeed.” If that’s really true, then Buffett’s words on the type of businesses that can withstand or even thrive against inflationary pressures would be well worth noting for any investor.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Berkshire Hathaway.