Inflation and Your Stocks
Unveiling the relationship between inflation and your stock portfolio
In a world of fast-paced news cycles, inflation numbers often dominate headlines, yet the true understanding of this economic concept remains elusive for many. As the media clamors to report rising or falling inflation rates, the average person might find themselves wondering, "What does this mean for me?" In this post, we'll demystify inflation, breaking down its causes and effects, and delve into the crucial connection between inflation and your stock investments. So, let's cut through the noise and uncover the insights you need to navigate the intricate dance between inflation and your portfolio.
I’ll be the first to admit that I have a sweet tooth and seldomly pass on the chance to munch on some chocolate. Back when I was a young boy my mom would give me R10( the equivalent of $0.52) so that I could buy my favorite chocolate. However during my latest trip to the grocery store, I had to fork out R30( the equivalent of $1.83) for the same brand and size of chocolate.
This is exactly what inflation is.
Inflation can be defined as the persistent general increase in prices of goods and services. This results in you buying less goods or services with the currency you have, which is basically a decrease in the purchasing power of money. Prices increase mainly due to two things:
Aggregate increase in demand
Decrease in supply
There are two types of inflation: Cost Push Inflation and Demand Pull Inflation. Cost Push Inflation is due to an increase in the cost of production. These increases in production costs can be due to an increase in wages, taxes or raw materials. If you are a candy company, an increase in the price of cocoa , the main ingredient in chocolate, will result in an increase in production costs which will be passed down to consumers; hence cost pull inflation.
We then have demand pull inflation. Demand pull inflation occurs when the demand for goods and services exceeds the supply. This can be due to an increase in money supply which can be caused by an increase in government spending/ stimulus. Imagine if the government dropped $1 million on everyone’s front yard. People will collectively be willing to spend more, instead of buying one box of chocolate they will buy three. The sellers notice this and then increase prices: hence causing demand pull inflation.
Now that inflation has been explained. How should investors act and what should they buy in an inflationary environment?
Before we dive in, we have to note that investors should think of their investments in terms of real returns. So if an investor achieves a 10% return but inflation over that period was 6%, then your real returns are only 4%.
“A business earning 20% on capital can produce a negative real return for its owners under inflationary conditions”- Warren Buffett
It is common knowledge that cash and bonds perform poorly in an inflationary environment. In an inflationary environment , “cash is trash”, and you don’t want to hold cash as its purchasing power is eroding. So where should you put your hard earned money to prevent this erosion?
Why do bonds perform poorly? With a bond, you are basically lending money to a company or the government. The company or the government in turn promises to pay back the money over a set period of time in fixed interest payments. Inflation is thus bad for bonds as it eats into the the future buying power of those fixed interest payments.
Stocks on the other hand have been viewed as a hedge against inflation. This however is not entirely true as stocks perform poorly in an inflationary environment as Warren Buffett points out in his Fortune article: How Inflation Swindles the Equity Investor. The main reason is that; while inflation has increased , the ROE(the equity coupon) of corporate America has not.
Inflation is the one thing that over a long period of time can turn investors results into a negative figure. It’s the investors enemy- Warren Buffett
But not all businesses are created equal. There are some businesses which can perform well in an inflationary environment. In Berkshire’s 1981 Shareholder letter, Warren Buffett lists the two types of businesses which are adapt to an inflationary environment.
The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. - Warren Buffett, Berkshire 1981 Shareholder letter
Buffett basically means that in an inflationary environment the two types of business that perform :
Businesses with pricing power
Businesses that require little capital investment to facilitate inflationary growth
We should look for business with pricing power, businesses that can pass on increases in costs to the customer. There are two types of pricing power: Nominal vs Real Pricing Power. Nominal pricing power is when a business can increase prices at a rate that only offsets inflation. Real pricing power is when the business can increase its prices in excess of inflation. The latter business is obviously preferred.
We should also look for business that require no/minimal capital requirements to facilitate growth. An example of such a business is a software company, in order to sell more copies of software minimal capital is required. This is in stark contrast to a capital intensive construction equipment lending business which will have to fork out large amounts of cash to buy more equipment in order to facilitate growth.
We will further go into why capital intensive businesses are horrible businesses to own in an inflationary environment. Using a construction equipment rental business as an example again. The company has to replace the equipment after a set period of time and will have to replace this equipment at the new inflated prices. This eats away from the inflationary driven sales growth.
As we've explored the essence of inflation, dissected its drivers, and grasped its effects, the pivotal link between this economic phenomenon and your stocks becomes evident. Just as inflation is an inevitable force in the economic realm, its impact on your investments is equally inevitable. By understanding how inflation erodes the value of money and impacts various asset classes, you're better equipped to tailor your investment strategies to navigate these shifting tides
The End.
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Thanks for putting this info out there for us!
Inflation, and the likelihood of it persisting higher and longer than imagined, are why we’re focused on hard asset, asset-light business models.