Strategies in an inflationary world

When inflation starts gnawing the purchasing power of currency, most investors wake up to the harsh reality of eroding wealth in real terms. For the people who have stashed their lifetime savings into fixed income instruments the question becomes a choice between enduring negative rates of real returns and embracing riskier asset classes.

In the week ended July, inflation touched 12.1%, its highest level in 13 years. However, fixed deposits in India yield 9-9.5% compared to more than 14% return you could get 13 years ago. As a result, the real rate of interest is hovering in negative territory, and it may remain there for some time.

In the ‘Intelligent Investor’, Ben Graham says that it is imprudent to have more than 75% of your net worth in fixed income securities. The reason: the threat of inflation. When you but a fixed deposit you are, in effect, assured that you would get a certain sum of money (principal plus interest) on maturity. However, the purchasing power of money at maturity will be less than the purchasing power of money at the time you invest.

Commodities with limited supply like oil and precious metals can give some protection against inflation; but in today’s world, where commodities are quoting a price close to their historical peaks, that option is too risky. Real estate used to be a good form of investment during the times of inflation; but here, again, the prices in the past decade have shot thorough the roof. The rise in interest rates will drive out all speculative demand and suppress the consumption demand. These factors together with rise in default rates will make real estate an unattractive investment choice. The signs of weakling of prices are already apparent all over the word.

A stock can be thought of as a claim on the future earnings of a company. Even during uncertain times of high inflation, you have better chances of getting high real returns from a careful selection of good businesses. Here is why.

Suppose a company earns $5 million in operating profit on total sales of $50 million. Let’s say that for two years inflation averages 10% p.a. Now suppose that the company is able to raise prices of its products at the same rate. Even if the output of the company remains the same, the revenues will grow at 10% per year in monetary terms. If the business is mature, the heads like depreciation and interest may not rise as much. This would enable the company to grow its profits at a pace more than 10% even when the physical output remains the same. However, there is a catch in this simplistic explanation. The working capital i.e. the money required to run day-to-day business (inventory, cash, receivables minus current liabilities) will grow due to higher prices. This means that the company will have to put in more capital to produce the same amount of physical output. Moreover, our assumption regarding the capability of the company to pass on the rising cost of inputs may not be true in a competitive environment.

On balance, it appears that in an inflationary environment, the businesses that would do well will have the following characteristics:
• Strong pricing power due to strong brands and other competitive advantages
• Low net working capital
• Low capital requirement in the immediate future
• Existence of long-term supply contracts of key inputs
• Large inventory of goods and materials whose prices have gone up

Inflation makes it hard to get good returns because of its macroeconomic impact. In most cases, it would cause the interest rates to rise affecting the growth adversely. Such times are characterized by a drop in confidence levels of the consumers, investors and businessmen resulting in a downward revision of asset prices. Sometimes the effects reach far and beyond, including, social unrest, changes in government etc.

Therein lies the opportunity for value investors. Inflation pokes a hole in the very fabric of a monetary economy. In such times, low confidence of consumers and businessmen, increasing unemployment, and uncertainty makes people to go defensive. Their reaction reminds me of the fabled chicken who shouts “sky is falling down” because a walnut falls on his head. He decides to tell the King, and on route meets other animals who join him in the quest, only to be eaten by the opportunistic Fox in the end.

Inflation is bad for the economy, and bad for most businesses; yet chickening out and stashing your money in fixed deposits is the worst thing you can do in such times.

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