Thursday, June 23, 2011

Surviving inflation part 1: Stocks

No matter how you cut it, inflation is a bad thing for your investments. Be that as it may, there are some investments that would be less affected by inflation than others. In this 2 part article series, I’ll be talking about 2 asset classes that can provide us with significant protection against inflation; stocks and treasury inflation protected securities or TIPS.

Businesses, whether it’s private businesses or stocks, have been and will continue to be the greatest generators of wealth over the long-term. Some would say that stocks are a good hedge against inflation as a company can raise prices to maintain profits in real terms. But that isn’t completely true as lousy companies might find it difficult to raise prices. In other words, stocks can be good hedges against inflation, but only stocks of good companies.

But shouldn’t we be investing only in good companies, regardless of whether or not there’s high inflation? Yes, we absolutely should. That’s why I’m always puzzled when people start panicking when there’s inflation and look to some guy on TV to tell them where to invest. If you invest in good companies at a reasonable price and hold on to those stocks for the long-term, you should do fine.

Here are a few characteristics we should look out for when identifying good companies that are resistant to inflation:

Good returns on capital

Good companies generate attractive returns on capital (hence the reason why they’re good). A company that’s asset-light and earns good returns on capital will be more resistant to inflation than one that’s asset-intensive and earns poor returns on capital. This is the case as in times of inflation, the company with a lower return on capital has to tie up more money in things like inventory and accounts receivable than a company that earns high returns on capital to stay even in terms of real profits.

For example: Suppose both company A and company B earns $1 million. But company A only needs to put up $5 million to earn the $1 million (high return business) while company B has to put up $20 million to earn $1 million (low return business). Now, let’s say that inflation has caused prices to double, and while both companies managed to increase prices at the same pace as inflation, both of the companies also had to put up two times as much capital just to stay even in terms of real profits. While inflation has hurt both companies, company A only needed to put up an extra $5 million in capital while company B had to put up an extra $20 million in capital.

It's hard to tell the exact return on capital a company enjoys as the company might be holding on to a lot of excess cash and etc. But generally, if a company consistently earn good returns on equity and good returns on assets without having to reinvest a lot of cash in the business to maintain profitability, then that would most likely be a company that can employ capital at good returns.

Pricing power

When trying to find good companies, it’s always useful to start out by looking for companies with strong brands that differentiate their offerings from that of their competitors and give them pricing power. But how do we know which company has a strong brand and which don’t? Doesn’t every CEO say that their company has a strong brand and pricing power? To answer this question, we need to look at the gross profit margin of the company and compare it to the gross profit margin of its competitors. If the gross profit margin is significantly higher, then the company has pricing power as customers are willing to pay more for the company’s products than for the products of the company’s competitors.

Here’s an example: There are 2 burger stands, both sells 100 burgers a day and the cost of the ingredients to make 1 burger (let’s just say $5) is the same for both burger stands. But if burger stand A has pricing power and is able to sell its burgers for $7 while burger stand B is only able to sell its burgers for $6, burger stand A will earn higher revenue than burger stand B ($700 for A and only $600 for B). And because both burger stand A and B have the same cost of ingredients at $500, but burger stand A has pricing power, burger stand A will earn a higher gross profit and have a higher gross margin than burger stand B. That’s why it’s important to look at the gross profit margin of a company in comparison to its competitors to determine if the company has pricing power.

Note: When I talk about using the gross profit margin to give us an idea of a company’s pricing power, I'm mainly talking about companies that sell physical goods. This method might not apply to certain industries or companies. There might also be more accurate methods to measure pricing power. But nevertheless, I think comparing the gross profit margin of a goods selling/producing company to that of its competitors is a good way to get a general idea of the company’s pricing power.

Operating profit margin

Good companies manage their costs well and should have higher operating profit margin than their competitors. By earning a higher profit margin relative to their competitors, good companies are able to weather inflation better than their competitors in the sense that they can better absorb cost increases (increases in raw material prices, increases in employees’ wages, and etc) than their competitors. They can wait a longer time before increasing the prices of their products and win market share from their competitors who have to pass on the costs to customers earlier or operate at a loss.

I believe the best way for investors to fight inflation is to do what they should always be doing regardless of what’s happening with the economy or how high inflation is going to get, that is to just invest in stocks of good quality companies at reasonable prices and hold those stocks for the long-term. Inflation might even cause stock prices to fall giving the savvy investor attractive buying opportunities.

If you have any questions, or have anything that you would like to add, please feel free to comment. Thank you for reading and may you always sustain good returns on your portfolio. Take care.