The Myth Of Stocks As An Inflation Hedge

With inflation ravenously eating through the dollar, uninvested cash is fast becoming a drag on every investor’s portfolio. At the current headline CPI of over 8%, a balance of $100,000 parked in a savings account loses over $650 a month in purchasing power. This alarming erosion of value will animate even the most conservative investors to seek out fortifications.

Traditional asset classes currently provide weak protection against the ravages of inflation – the entire universe of bonds (including below-investment-grade ones) yield far below the CPI rate; real estate provides no recourse either (cap rates on most classes of real estate hover between 3% and 6% today).

That leaves equities – and, prima facie, they seem like an attractive option. After all, when input costs rise, the businesses can simply increase the prices of their products, and thereby retain their earning power. But the reality is somewhat more nuanced than this.

Inflation: The Good, the Bad and the Ugly

The pervasive belief that business results are inflation resistant is based upon the simplistic assumption that as input costs (primarily wages and raw materials) rise, the price of the end product can also be raised, and therefore the net impact to a business is neutral. This heuristic short-cut used by many investors overlooks several intricacies, I delve into a few below.

The Good

Businesses do enjoy favorable outcomes from inflationary forces – albeit they occur only during the early phases of inflation, and only benefit certain types of businesses.

During the initial period of inflationary onset, companies benefit from lower input costs, usually in two areas – raw materials and labor. An immediate short-term boost in income comes via margin expansion when inventory that was purchased in older, cheaper dollars are now sold as finished goods at newer, higher prices. Labor costs also experience a lag before fully catching up with inflation – primarily because worker’s salaries are generally revised only once a year; and in the case of unionized or collective-bargaining situations, these are often contractually locked in for several years (most labor agreements shed cost-of-living adjustment clauses over the years – albeit they are now making a comeback).

Companies that incur high fixed costs also enjoy some transient benefits during inflationary periods. Players in sectors such as heavy manufacturing, pharmaceuticals, airlines, etc. need to make large upfront capital outlays for building factories, purchasing equipment, investing in large R&D projects, etc. before they can begin profitable production and sales. These types of businesses are positively impacted by inflation in two ways.

1. Cost Structure Improvement: A business that has a large fixed cost suffers a drag on profitability until it overcomes the break-even point between sales and fixed costs. Once this occurs, profitability soars on all subsequent incremental sales. Inflation makes it easier for businesses to attain the break-even point – since the fixed costs were incurred using fewer dollars in the past, while current sales are priced in more numerous inflated dollars. The result is that sales gain a “profitability lift” sooner and achieve wider margins more rapidly.

2. Widening of Moat: In an inflationary environment established players who already paid their “capex dues” (via previously incurred large investments) erect a barrier against new entrants. Any potential new entrant will face a competitive disadvantage, since they will have to pay a higher cost to achieve production parity, and additionally, will suffer an ongoing drag of larger fixed-cost depreciation.

Neither of these benefits endures, however: since the aging equipment will eventually require replacement (more on that topic later).

Another transitory benefit that businesses enjoy during the early stages of inflation is the lag between rates of inflation and interest rates. During this lag, inflation rates run ahead of borrowing costs creating a “free ride” that contributes to the temporary widening of profit margins.

The Bad

Although businesses can exploit the delay between labor, inventory, capex and borrowing costs catching up with inflation, these gains will eventually dissipate. The bad and ugly outcomes will then begin to rear their heads. Let’s start with the bad.

In the context of inflation, the bad news for investors is that the return that a business earns on its equity (RoE) does not vary very much between inflationary and non-inflationary environments – this is because inflation equally impacts all the inputs that determine RoE, cancelling each other out. Warren Buffett’s classic 1977 article on inflation describes this phenomenon in great detail.

The upshot is that owning shares in a business that earns 12% RoE becomes far less attractive when inflation is running at 8%, versus when inflation takes out a smaller bite of 2%.

The Ugly

The longer that inflation persists, the more ruinous its effects are on business returns and therefore on the ownership shares in them. The key variables creating these deleterious effects include the following.

1. Interest Rates: Inflation is a blessing to those who have borrowed and curse to those who have lent. This is because the borrowers pay interest (and principal) in the new inflated dollars, while the lenders originally lent out in more valuable older dollars. But lenders won’t be willing to play this game for long: When new loans are made or when debt comes up for rollover they will demand interest rates that compensate for inflation, thereby pushing up borrowing rates. The higher debt-servicing costs will of course pull down the profitability of businesses.

Additionally, a rise in interest rate has a multiplicative effect – it increases financing costs all along the company’s supply and value chain. The cumulative impact of higher interest rates to businesses is therefore acute.

2. Replacement capex: Maintaining the productive capacity of a business requires ongoing capital expenditures on PP&E (plant, property & equipment). However, inflation-induced higher costs of replacement eats into the company’s cash flow. As inflation escalates, businesses burn through increasing portions of their cash flow just to stay in place.

3. Pricing Power: Although part of the escalating costs caused by inflation can be passed onto the consumers, fear of losing market share acts as a restraint on this. Very few businesses have true pricing power; in most cases, market forces conspire against a business’s ability to increase prices easily. This limited pricing power further compresses margins and profitability.

4. Taxation: In many major tax jurisdictions (domestic and global), income tax tiers are bracketed by fixed cutoffs and are not indexed to inflation. The net effect is that when inflation raises a company’s nominal income, it gets pushed into higher tax brackets although no rise in real income would have occurred. This so-called “bracket creep” further erodes the profitability of businesses.

The Gravitational Pull of Inflation: What Can Take Flight

Given all of this, are there any industries or sectors that can overcome the pull exerted by inflation? Businesses that have incurred high fixed costs in the past have long-lived productive assets, require minimal ongoing replacement expenditures, and have low variable costs are potential candidates. What are these? Unlevered REITs, timberland companies, and mineral and oil/gas royalties fall into this category. Companies that have strong pricing power (and usually possess a strong brand following) also are likely to sustain strength.

The bottom line is as follows: In an inflationary environment, the combined impact of higher interest rates, corrosive replacement capex, limited pricing power, higher tax rates, and stagnant returns on equity drag down business performance, and therefore make equities a weak shelter against the ravages of inflation.