By now, post-pandemic inflation likely has hit your wallet, whether at the supermarket, gas station or virtually anywhere else you buy goods and services these days. But how will inflation impact investment portfolios?
When analyzing securities for a company, inflation has two primary effects. It can impact profitability and raise the hurdle rate of return for its stock. A hurdle rate is the minimum return required to make a specific investment attractive. Following investment strategies that take both company profitability and expected returns into account may help investors achieve their objectives despite an inflationary environment.
As we all know, inflation increases prices. Is that good or bad? Depends.
Indeed, a company’s revenues and expenses increase during inflationary times. In general, if a company is profitable and capable of passing rising prices to consumers, modest to moderate amounts of inflation can increase the firm’s dollar profits (all else being equal). At greater levels of profitability, greater inflationary effects benefit profitability. On the other hand, if a company is losing money, inflation amplifies those losses.
Either way, inflation will increase hurdle rates of return. Even if a company’s profitability might improve, you still need to reevaluate whether the company stock is a worthy investment. Generally, investments that exceed the hurdle rate can be considered attractive. So, inflation makes every investment less attractive in general because all hurdle rates increase proportionately with inflation. That means borderline investments that were more desirable at lower levels of inflation might flip and end up dropping below their hurdle rates.
Broadly speaking for a typical portfolio, investment returns for stocks and bonds can be influenced by:
The return a company achieves on capital directly invested in its operating assets. As inflation raises hurdle rates, it becomes harder for companies to generate sufficient returns on the capital they invest in operating assets. So, it’s wise to look for the companies that provide the highest return on total assets.
The return an investor receives by buying a company’s stock. Investors want stocks with attractive valuations and should look for those with higher returns on market equity.
The negative impact that inflation and the related rising interest rates have on fixed income investments like bonds. Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. Selecting low duration investments manages the pricing risk that inflation introduces.
Inflation is ruining the party by disrupting many commercial and industrial supply chains and consumer prices. Stock analysts, investment advisors and individual investors are forced to consider its impact on their portfolios.
We believe these four investing tips could prove helpful in this inflationary environment:
Seek out the most profitable companies.
The most profitable companies’ income statement/profits will benefit from inflation, while the unprofitable ones will see widening losses. Target those companies that generate the most profits and stand to gain the most from inflation.
Favor companies with the highest “ROTA.”
Return on Total Assets (or ROTA) is simply a company’s profits divided by its total assets. With hurdle rates increasing, seek to select companies that generate very high returns on capital internally. For these companies, even large increases in inflation would have a lesser impact on their internal growth and investment programs.
Select stocks with the highest “ROME.”
Return on Market Value of Equity (or ROME), calculated as cash profits divided by stock price, is used to identify companies that trade at the lowest valuations/cheapest prices. The higher the ROME, the cheaper the price, just like the yield on a bond. It may help to think of ROME (Earnings/Price) as the inverse of the P/E Ratio (Price/Earnings); therefore, a high ROME and low P/E both indicate cheaper prices. Since higher hurdle rates call for stocks with the highest cash-flow yields, a better ROME gives you the greatest margin-of-safety against climbing hurdle rates driven by inflation.
Avoid long duration fixed income investments.
Rising hurdle rates and interest rates over time means long duration investments are at risk of generating very low, and possibly, negative returns. Consider replacing long duration investments in a portfolio with shorter duration or duration insensitive asset classes.
Investors do not have to watch inflation erode their returns. Ultimately, a sweet spot for investors could be with stocks that have both a high ROTA and high ROME. Some smart, proactive portfolio changes can combat the pressure that rising prices will place on investors’ returns.