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Buffett and Munger: How to Protect Against Inflation

Inflation is one of the most significant risks investors have to deal with over the long term. The topic, however, is usually at the back of their minds when choosing stocks.

Most investors look for stocks that have the potential to generate the best returns over the long term, such as cheap value stocks, rather than companies that can weather the detrimental impact of inflation on earnings over the next several decades.

But as Warren Buffett (Trades, Portfolio) explained at the 2004 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual meeting of shareholders, investors should be looking for businesses that can defend against inflation because these tend to be the market's best companies.

When one shareholder asked Buffett for his thoughts on inflation, his immediate response was to praise the importance of "purchasing power" or competitive edge:

"The best thing is to have a lot of earning power of your own. If you're the best brain surgeon in town, or even the best lawyer in town, you will retain purchasing power, in terms of your income, no matter what happens, you know, whether people are using seashells for money, or whatever as time goes by."

Unfortunately, most companies don't have this kind of competitive edge, so they will find it difficult to survive an inflationary environment. As Buffett went on to explain:

"You know, the worst kind of a business is one that makes you put more money on the table all the time and doesn't give you greater earnings. So you really want a business that can have pricing that reflects inflation and does not have very much capital investment that reflects inflation. But inflation is the enemy of the investor, in terms of real returns."

Buffett then handed the microphone over to Charlie Munger (Trades, Portfolio), who went on to declare that most investors will suffer somewhat unattractive returns over the long term after taking into account inflation and taxes. "I think that's an iron law of the world," he concluded.

The best way to get around this problem, in Munger's view, is to own fine businesses that will be able to price in inflation returns without large capital spending requirements, with a view to never selling them. If you find these businesses, you can sit on the stock for decades and not have to worry about the scourge of inflation on returns.

Another piece of advice to protect against inflation Munger offered was to avoid having "silly needs" in your life. This included "artificial demand" for consumer goods, which you want but don't need.

If you can avoid the pull of these products, "you have a considerable defense against the vicissitudes of life," Munger summarized.

These tips from Munger and Buffett are fantastic because not only do they offer some advice for protecting your money against the scourge of inflation, but they also give us information on how to select investments in general and manage money effectively so that we don't waste it.

Following just these two pieces of advice could be transformative for most investors and savers.

By avoiding spending your money on unnecessary goods and services and then reinvesting this money into high-quality companies with pricing power and a strong competitive advantage, there is no need for lots of capital spending.

This is a simple investment strategy, but the results could be fantastic. You just have to look at the way Munger has managed his personal portfolio over the past several decades. He only owns a handful of stocks and doesn't spend a lot of money on unneeded products.

To a certain extent, Buffett also follows a similar approach, though research shows that he has been much more active as a trader.

Disclosure: The author owns shares of Berkshire Hathaway.

Read more here:

  • What Warren Buffett Learned From Phil Carret's Investment Style
  • Warren Buffett, World Book Encyclopedia and Scott & Fetzer
  • When to Buy a House According to Warren Buffett

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This article first appeared on GuruFocus.