2018 began with a jolt to the stock market, resulting in a surge in the fear index (VIX), attributed in large part to fears of increasing inflation. Inflation is widely believed to be detrimental to bonds, but there are conflicting opinions on how it influences stocks. So just how does inflation affect stocks?
How Does Inflation Affect Stocks? It’s Complicated
On one side, stocks are considered to be a hedge against inflation because their underlying productive facilities generate revenue that increases in proportion to inflation (while bonds are mere claims against dollars).
But historically, stocks have delivered above-average returns at times of low inflation and below-average returns at times of high inflation. Why is that?
While it’s true that stocks are backed by productive facilities that generate revenues that are hedged to inflation, the income-generating facilities are susceptible to inflationary pressures. So to understand the forces that nullify the inflationary advantages on revenue, we need to take a look at how inflation acts on the components of a business.
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On the asset side of the balance sheet, inflation increases the replacement cost of both inventory and fixed assets, while receivables increase in proportion to the inflationary growth in revenue.
On the liability side of the balance sheet, inflation results in an increase in leverage by less profitable companies to sponsor their capital requirements. Altogether, the assets and liability sides of a company’s balance sheet will bloat in proportion to inflation.
On the equity side of the balance sheet, we need to factor various costs that are directly associated with expanding assets and liabilities. Increasing replacement costs of inventory and fixed assets will increase the cost of goods sold and depreciation expenses. At the same time, growing liabilities in the less profitable companies, along with rising interest rates, will result in higher overall interest expenses.
So, getting back to my original question: just how does inflation affect stocks? In a nutshell, the positive impact of inflation on the top line will be nullified by various associated costs, resulting in a neutral bottom line.
So the equity side of the balance sheet faces almost no impact from inflation, resulting in a neutral return on equity but a higher debt-to-equity ratio.
Warren Buffett in his 1977 Fortune article, ‘How Inflation Swindles the Equity Investor,’ describes stocks as nothing but perpetual bonds. Buffett argued that the return on equity of a stock has been consistent at about 12% in the post-war era. Revisiting this magic rate in 2018, we notice that on a 10-year rolling basis, the rate has not changed much since 1977. The return on equity is akin to an ‘equity coupon’ (equity’s relatively higher coupon rate compared to bonds can be attributed to the inherent risk associated with stocks, especially due to their perpetual nature).
As in Einstein’s theory of relativity, where the speed of light is considered to be a natural constant and everything else including time and space are malleable, in the theory of common stocks, the equity coupon may be considered as universally constant (albeit far from precise). When the return on equity is a constant and leverage is soaring, inflation increases the overall risk of a stock.
Inflation This Time: More Upside than Downside
The increased risk will eventually be judged with greater caution by the market, resulting in a lower valuation. For instance, if a stock with $100 book value with a debt-to-equity ratio of 2x has a price-to-book-value ratio of 1.5x, then the same stock with a debt-to-equity ratio of 3x should have a price-to-book-value ratio of lower than 1.5x. Thus, a stock trading at $150 of market capitalization at the times of lower inflation rate will trade lower than $150 at times of higher inflation.
As a corollary, we may also assume that any extraordinary event that would improve the earnings of a stock, such as a sudden cut in the tax rate or an innovation leading to a higher operating margin, would cancel out the negative influence of inflation on the stock price, and result in neutral leverage—but the effect of such an extraordinary event would not continue in the long run.
As I evaluate the broader economic picture of 2018, I see that the upside potential for inflation is much more probable than the downward potential. Keeping this in mind, along with the probable upside potential of interest rates, there’s a significant chance that the market will value stocks less dear in next five to 10 years. This doesn’t imply that stock prices will go down in the next five to 10 years—the continued strength in the economy, together with ample room for productive expansion, could mitigate the effect of inflationary pressures on stock valuation—but it does suggest that investors looking for protection from an inflationary environment should seek out stocks whose income is hedged from inflation to a reasonable extent.
And that’s exactly what I recently recommended to subscribers of Cabot Benjamin Graham Value Investor.
Sincerely,
Azmath Rahiman