Why inflation discriminates between my stocks?
Inflation discriminates - this is not about wealth inequality but how some stocks take a bigger hit from inflation.
Inflation has been the talk of the town lately. The Dow Jones Industrial Average (a basket of stocks with stable cash flows) is down ~8% year-to-date while the NASDAQ Composite (seen as a representative of new-age disruptive stocks) is down ~18% in the same period. There are multiple factors causing this slump in valuation - inflation being one of them. The value vs growth dynamic we will look at, explains this “discrimination.”
The general perception is that equity markets tend to take blow when inflation steps up. One piece of news about the Fed chair intimating an increase in rates and the valuations start seeming to be too high. But never does inflation affect every stock on the bourses equally. There are millioooooons of macroeconomic variables that come in to play here. But at the micro-level, two specific factors are the most influential ones. These two factors generally tend to decide how two stocks in the same macro environment react differently to inflationary pressures.
Cash Flow Mechanics - The value vs growth stocks debate finds a strong distinction point in an inflationary settings. Growth stocks usually suffer more than their value counterparts. Why is it so?
Growth stocks represent the companies which derive a large chunk of their valuations from expectations of higher future cash flows. Take Tesla as an example. It’s high valuations are justified not by it’s current profit levels but by the belief that in EV future will disrupt the automobile industry and Tesla is positioned to benefit from it. On the other hand, value stocks have stable and mature cash flows. Coca Cola is one of these, you don’t see it’s cash flows rocketing exponentially in the future, it’s already there.
Now why does inflation seem to hate growth stocks more? Technically speaking, a Discounted Cash Flow method of valuation, as rates increase, stocks with cash flows from far off in the future will be worth very less today and similarly, cash flows from the present will contribute to valuations much more heavily. And this is exactly why the NASDAQ suffered a much bigger blow compared to the DJIA.
That was jargon laden financial theory. But you could think of it this way as well. During inflation, money loses value over time. As time progresses, money will keep losing value. $100 15 years from now will be worth much less valuable than $100 2 years from now. And as inflation increases, the difference becomes starker.
Another way you could look at it is from the company’s financial costs perspective. A company is able to earn the revenues it is earning because it has invested some capital funds in the business. And that capital has some costs. Debt needs to be serviced with interest and repayments. Equity has a notional cost as the money put in here could be invested somewhere else - opportunity cost is attached with these funds. And as inflation increases these costs increase, the cost of debt and the cost of equity both increase, dampening the margins and thus the overall profitability, in turn lowering the valuations.
Business & Market Position - Inflation does increase the cost of running a business. But if the company can pass on these costs to the consumers in the form of higher prices, inflation wouldn’t cause a lot of disruptions. And to be able to do so, the company must have strong enough position in the market to do so. Or it might as well operate in an industry where it is easily possible to shift the burden of higher costs to the consumers - essential commodities like staple foods or small ticketed purchases like a pack of everyday tea. Brands and companies which can do so, might not need to worry about inflation as much as their counterparts might want to.
Is inflation harmful? High inflation sure is. Inflation without accompanying growth in the economy is. But if the growth rate is higher than the inflation, there is little to worry about. Some companies might even benefit out of inflation. Corner offices of banks, insurance companies and oil and gas companies do not have as worried environments as others might have. They in fact, could benefit out of inflation for multiple reasons. Similarly, if you can match your topline growth with inflation rates or outpace it, the stock could do well on the exchanges. After all, stock prices are nominal, not real.
Amazing work!
Amazing soumil!