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Investing in inflationary times - Views on News from Equitymaster
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Investing in inflationary times
Apr 4, 2008

After sub prime, another word that has been giving policymakers across the globe sleepless nights is inflation. Rising prices of commodities, especially that of crude, food grains and metals is wreaking havoc on the growth prospects of both developing as well as developed countries alike and has even led some of the world’s leading financial institutions to cut the world’s GDP growth forecasts by a few percentage points. It is not as if the globe has not faced these problems before but the demand push that is being exerted by almost half of the world’s population residing in the famed BRIC countries is almost unprecedented in its scale and magnitude. After remaining closed for years, the forces of capitalism have been unleashed in these countries, resulting in rising aspirations. A whole swathe of humanity in these parts of the world wants to have a lifestyle like an average American or a European. They want to eat at swanky restaurants, move around in posh cars and dress up in designer clothes. We see no wrong in that. Everyone should have some kind of aspiration levels in life. But the big question is are our factories and farmlands prepared to meet the demand of such a magnitude? Or are our oilfields and mines primed well enough to dig out rare minerals in ever increasing quantities? Sadly, the answer to these questions is in the negative and the results are there for everyone to see. It is a simple rule of supply and demand. Years of underinvestment in agriculture and the natural resources industries has led to production stagnating and hence the entire world was caught napping when demand began to surge. While eventually things would correct as people try to shift their production towards meeting the incremental demand, it is a time consuming exercise and till such time, the world will have to put up with higher prices aka inflation.

Governments across the world are trying their best to curb this menace and as usual, the axe is likely to fall on industries, which exert significant influence on the inflation figures. These would be mostly agricultural and non-agri based commodities, the industries, which provide raw materials to quite a few downstream industries and hence, act as a very good control point. However, steps like price controls and export restrictions, which are in the interest of the overall economy and the population at large, are not so welcome by shareholders of the companies that produce these commodities. After all wealth is created when earnings go up but when restrictions are put on them, shareholders are deprived of their expected upsides.

Thus, with a whole lot of industries coming under indirect price controls or facing the brunt of higher inflation, which are the industries or companies that are best suited to thrive under these conditions and how should an investor go about finding these companies? The answer is not difficult to find. Inflation is best tackled by a company, which has two important characteristics, a history of high and stable margins and little or no debt on its balance sheet. Stable margins would mean that the company has been passing on the burden of high raw material prices by affecting a proportionate rise in its realisations per unit sold. This is only made possible on a consistent basis by offering a product that has some very strong competitive advantages and is not easily copied or imitated by competition, thus always commanding a premium. Further, since higher inflation usually leads to high interest rates, it is important that a company has very little debt on its books so that higher interest rates do not impact its profitability during inflationary times. While a company possessing these characteristics are well placed to give its shareholders attractive returns at all times, they become all the more safe during inflationary times. However, an investor needs to be wary of the fact that such a company has reasonable valuations vis-à-vis its earnings expectations and has a good margin of safety incorporated in its stock price.

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