Inflation and Impact on Stock Prices

Inflation and Impact on Stock Prices

On the weekend, investors/founders asked me my view on 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐚𝐧𝐝 𝐢𝐭𝐬 𝐢𝐦𝐩𝐚𝐜𝐭 𝐨𝐧 𝐬𝐭𝐨𝐜𝐤 𝐩𝐫𝐢𝐜𝐞𝐬. inflation continues to be the main topic when projecting the future of the economy and markets.

I shared my framework for picking the right stocks that act as an inflation hedge to invest in, as Inflation impacts every value driver of valuation.

𝗩𝗮𝗹𝘂𝗲 𝗼𝗳 𝗮 𝗯𝘂𝘀𝗶𝗻𝗲𝘀𝘀 = 𝗥𝗲𝘃𝗲𝗻𝘂𝗲𝘀𝗢𝗽𝗲𝗿𝗮𝘁𝗶𝗻𝗴 𝗠𝗮𝗿𝗴𝗶𝗻(𝟭-𝗧𝗮𝘅 𝗿𝗮𝘁𝗲)-𝗥𝗲𝗶𝗻𝘃𝗲𝘀𝘁𝗺𝗲𝗻𝘁 𝗱𝗶𝘀𝗰𝗼𝘂𝗻𝘁𝗲𝗱 𝗮𝘁 𝘁𝗵𝗲 𝗰𝗼𝘀𝘁 𝗼𝗳 𝗰𝗮𝗽𝗶𝘁𝗮𝗹 (𝗳𝘂𝗻𝗰𝘁𝗶𝗼𝗻 𝗼𝗳 𝗿𝗶𝘀𝗸-𝗳𝗿𝗲𝗲 𝗿𝗮𝘁𝗲, 𝗰𝗼𝘀𝘁 𝗼𝗳 𝗱𝗲𝗯𝘁, 𝗲𝗾𝘂𝗶𝘁𝘆 𝗿𝗶𝘀𝗸 𝗽𝗿𝗲𝗺𝗶𝘂𝗺, 𝗮𝗻𝗱 𝗯𝗲𝘁𝗮).

Inflation affects every value driver in the above equation as follows:

𝐑𝐞𝐯𝐞𝐧𝐮𝐞𝐬: Companies with higher pricing power can transfer higher prices to customers due to Inflation without any consequences. Thus firms with higher market share should perform well.

𝐌𝐚𝐫𝐠𝐢𝐧𝐬: Companies with higher input costs (commodities/labour) operating in a highly competitive environment will witness a margin compression due to the inability to transfer high costs to customers.

𝐑𝐞𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭: Companies with higher reinvestment needs may need to incur reinvestment at a higher price due to Inflation that can compress their ROIC. Thus, capital-intensive firms that can defer their CAPEX should perform better than firms that cannot.

𝐑𝐢𝐬𝐤-𝐟𝐫𝐞𝐞 𝐫𝐚𝐭𝐞: As central banks globally have increased interest rates, companies with higher D/E ratios should incur higher debt costs, reducing value.

𝐄𝐪𝐮𝐢𝐭𝐲 𝐫𝐢𝐬𝐤 𝐩𝐫𝐞𝐦𝐢𝐮𝐦: With higher Inflation, the investors will demand a higher return from investing in equities, increasing the equity risk premium, in turn reducing value.

𝐁𝐞𝐭𝐚: Firms with unproven business models and burning cash are riskier than mature firms with stable cash flows. Thus new-age start-ups that burn cash or distressed firms with a higher cost of debt have a higher risk of shutting down.

Thus, 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐢𝐦𝐩𝐚𝐜𝐭𝐬 𝐞𝐯𝐞𝐫𝐲 𝐝𝐫𝐢𝐯𝐞𝐫 𝐨𝐟 𝐯𝐚𝐥𝐮𝐚𝐭𝐢𝐨𝐧 and investors looking to invest should focus on the following stocks:

𝐒𝐦𝐚𝐥𝐥-𝐜𝐚𝐩 companies with 𝐥𝐨𝐰𝐞𝐫-𝐏𝐫𝐢𝐜𝐞 𝐭𝐨 𝐁𝐨𝐨𝐤 𝐫𝐚𝐭𝐢𝐨𝐬, 𝐥𝐨𝐰𝐞𝐫 𝐝𝐞𝐛𝐭 𝐭𝐨 𝐞𝐪𝐮𝐢𝐭𝐲 𝐫𝐚𝐭𝐢𝐨𝐬 and 𝐬𝐭𝐚𝐛𝐥𝐞 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬 should perform better than growth companies burning cash.

Thus, in my view, investing in boring matured companies like 𝐄𝐧𝐞𝐫𝐠𝐲, 𝐔𝐭𝐢𝐥𝐢𝐭𝐢𝐞𝐬, 𝐚𝐧𝐝 𝐜𝐨𝐧𝐬𝐮𝐦𝐞𝐫 𝐬𝐭𝐚𝐩𝐥𝐞𝐬 𝐭𝐡𝐚𝐭 𝐩𝐚𝐲 𝐯𝐚𝐬𝐭 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝𝐬 𝐚𝐫𝐞 𝐛𝐞𝐭𝐭𝐞𝐫 𝐛𝐞𝐭𝐬 if higher Inflation continues.