2011: What is more inflation-proof: a capital-light business, or an asset-heavy business with pricing power?

AUDIENCE MEMBER: Good morning. Angie Janssen (PH) of Cambridge, Massachusetts.

My question is, aside from the need to put huge amounts of capital to work, do you still believe that a high return on tangible capital business, like See’s or Coke, is the best asset to hold in an inflationary environment, or do you now think an irreplaceable hard asset with pricing power, like a railroad or a hydroelectric dam, is superior?

WARREN BUFFETT: The first group is superior. I mean, if you can have a wonderful consumer product — doesn’t have to be a consumer product — a product that requires very little capital to grow, and to do more dollar volume, as will happen with inflation even if you don’t have unit growth, and it doesn’t take much capital to support that growth, that is a wonderful asset to have in inflation.

I mean, the ultimate test of that is your own earning ability. I mean, if you’re an outstanding doctor, lawyer, whatever it may be, teacher, the — you — as inflation goes along, your services will command more and more in dollar terms, and you don’t have to make any additional investment in yourself.

People think of that, you know, with a very long-lived real estate asset or something of the sort, or a farm, or anything where additional capital is not required to finance inflationary growth.

The worst kind of businesses are the businesses with tons of receivables and inventories and all of that.

And in dollar terms, if their volume stays flat but the price level doubles, and they need to come up with double the amount of money to do that same volume of business, that can be a very bad asset.

Now normally, we are not enthused about businesses that require heavy capital investment, just like utilities and the railroad.

We think that, on the other hand, particularly with the railroad, that where you do not have any guaranteed lower rate of return, that you should be entitled to earn returns on assets that are becoming more and more valuable to the economy as — whether it’s because of inflationary factors or because of just natural growth factors, or in the case of the United States, I think it will be both.

But the ideal business — See’s Candy is doing — it was doing $25 million of volume when we bought it, and it sold 16 million pounds of candy — a little more than — well, it retails $1.90, and we had some quantity discounts, so we were doing close to $30 million worth of business.

Now, we’re doing well over $300 million worth of business. It took $9 million of tangible assets to run it when it was doing 30, and it takes about 40 million of tangible assets at 300-and-some.

So we’ve only had to ploy back $30 million into a business which will make us — well, it’s made us, probably, a billion-and-a-half pretax during that period.

And if the price of candy doubles, we don’t have any receivables to speak of. Our inventory turns fast. We don’t store it or anything like that. We gear up seasonally and the fixed assets aren’t big, so that is a much better business to own than a utility business if you’re going to have a lot of inflation.

Charlie?

CHARLIE MUNGER: And what’s interesting about it is that we didn’t always know this. And so — (Laughter)

WARREN BUFFETT: And sometimes we forget it. (Laughter)

CHARLIE MUNGER: That’s true, too.

But it shows how continuous learning is absolutely required to have any significant achievement at all in the world.

WARREN BUFFETT: Yeah, and it does show — you know, I’ve said in the past that I’m a better businessman because I’m an investor and I’m a better investor because I’m a businessman.

There’s nothing like actually experiencing the necessity, particularly in the 1970s when inflation was gathering strength, and early ’80s, you would see this absolutely required capital investment on a very big scale that really wasn’t producing anything commensurate in the way of earnings.

I wrote an article for Fortune called “How Inflation Swindles the Equity Investor” back in 1977.

You really want — the ideal asset, you know, is a royalty on somebody else’s sales during inflation, where all you do is get a royalty check every month, and it’s based on their sales volume.

And you made — you came up with some product originally, licensed it to them, and you never have another bit of capital investment. You have no receivables, you have no inventory, and you have no fixed assets.

That kind of business is real inflation protection, assuming the product maintains its viability.

So even though we are going into some very capital-intensive businesses, part of that reflects the fact we can’t deploy the amount of capital we have in a whole bunch of See’s Candies. We just can’t find them. We would love to find them, but we can’t find them in that quantity.

So we are not doing as well with capital when we have to invest many billions a year, as we would if we were investing a few millions a year. There’s no question.

That’s true in investments. It’s true in operating businesses. There is a real disadvantage to size, and we just hope that problem grows.

CHARLIE MUNGER: Now you’re talking.