Tracking inflation: the disparate effects on corporate values

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In my last article, I explained how the yield of inflation has changed the calculus for investors, looking at how inflation affects the returns of different asset classes and plotting the consequences for stock values, generally. In general, more and more volatile inflation has negative effects on all financial assets, from stocks to corporate bonds to treasury bills, and neutral to positive effects on gold, collectibles and real assets. That said, the impact of inflation on individual company values ​​can vary widely, with a few companies benefiting, some only mildly impacted, and others being hit harder by higher than expected inflation. In an environment where finding inflation hedges has become the top priority for most investors, the search for companies less exposed to high and rising inflation is ongoing. Conventional wisdom, based largely on the experiences of investors in the 1970s, is that commodity companies and companies with pricing power are the best to hold, if you fear inflation, but is- this true, and even if it is true, why is it so? To answer these questions, I will return to the fundamentals and attempt to trace the effects of inflation on the drivers of value, with the aim of finding the characteristics of stocks with better inflation hedging properties.

Inflation and value

When in doubt about how an action or piece of information translates into value, I find it helpful to go back to the basics of value and trace the effects of that action/information on the drivers of value. Following this rulebook, I examined the effects of inflation on the levers that determine value, in the chart below:

Inflation: the disparate effects on corporate values

Simply put, the effects of inflation on business value boil down to the impact of inflation on expected cash flow/growth and risk. At the risk of rephrasing what is already in the chart above, the factors that will play into determining the ultimate inflation impact on value are in the table below:

Inflation: the disparate effects on corporate values

If you were looking for a business that would operate as a hedge against inflation, you would want it to have pricing power over the products and services it sells, with low input costs, and operating in a business where investments are short-term and reversible. On the risk front, you’d like the business to have a large, stable revenue stream and low debt.

Looking back

There are lessons that can be learned from looking at the past, about how inflation affects different groups of businesses, although there is the danger of over-extrapolation. In this section, I first examine how stock classes have performed over the decades and relate that performance to inflation (expected and unexpected). I then look at the performance of equities in the less than five months of 2022, where inflation has returned to the headlines.

Historical data: 1930-2019

To see how this framework works in practice, let’s start by looking at the performance of US stocks, over the decades, and look at stock returns, generally ranked by market capitalization and price-to-book ratios. The first is a shortcut for the small cap premium and the latter is the proxy of the value factor in returns.

Inflation: the disparate effects on corporate values

The distinction I made between expected inflation and unexpected inflation comes into play in this table. It is unexpected inflation that seems to have a big impact on the behavior of small cap stocks, outperforming during the decades when inflation was higher than expected (1940-49, 196069, 1970-79) and underperforming during the decades when inflation was lower than expected (1990-99, 2010-19). The value effect, measured as the difference between low and high stock prices, was greatest in the 1970s, when actual and unexpected inflation was high, but remained resilient in the 1980s. when inflation remained high, but declined. expectations.

The 2022 experience

As the focus has returned to inflation over the past five months, it’s worth looking at the performance of US equities, broken down by different categories, to see if the patterns of the past are playing out in US markets. today. To start, let’s look at how the damage of inflation on equities varies across sectors, looking at 2022 broken down into three tranches, returns in the first quarter of 2022 (when Russia vied with inflation for attention market), the period from April 1 to May 19, 2022 (when inflation was the dominant story) and the entire year to date.

Inflation: the disparate effects on corporate values

In 2022, the collective market capitalization of all U.S. companies fell 19.75%, with most of the decline occurring after April 1, 2022. Over the period (April 1 – May 19, 2022), the three worst performing sectors (highlighted) were ttechnology, consumer discretionary and communication services, and the best performing sectors were energy (no surprise, given the rise in oil prices) and utilitiesold investor watches during tumultuous times.

To test whether the outperformance of small caps and low price-to-book ratios that we saw in the 1970s is repeated in 2022, I have broken down companies by decile (based on market capitalization and book price at beginning of 2022), and examined the evolution of the overall value in 2022:

Inflation: the disparate effects on corporate values

As in the 1970s, the small-cap premium appears to have come back strong, as small-cap stocks outperformed large-cap stocks in 2022, and the low price to book stocks hurt less than the high price to count the shares. To examine the interaction and performance of stock prices in 2022, I looked at the aggregate returns of companies ranked in deciles based on both equity risk (betas) and default risk (with bond ratings):

Inflation: the disparate effects on corporate values

The link between equity risk and equity returns supports the hypothesis that riskier companies are more affected by inflation, with one exception: stocks with the lowest betas also performed poorly in 2022. bond ratings, there is no discernible link between ratings and returns, until you get to the lowest rated bonds (CCC and below). In a final assessment, I break down companies by operating cash flow (EBITDA as a percentage of enterprise value) and dividend yield (dividends as a percentage of market capitalization).

Inflation: the disparate effects on corporate values

Companies that generate more cash flow from their operations and return more of that cash flow as dividends to shareholders have clearly retained their value better than companies with low or negative cash flows that do not pay of dividends, in 2022. In view of these results, value investors will no doubt find vindication for their beliefs that this is a long overdue correction, i.e. a return to normal where safe stocks in boring sectors that pay high dividends offer excess returns. I think given how consistently growth stocks have beaten value stocks over the past decade, a correction was in order, but I think it’s far too early to proclaim the return of old fashioned value investing.

Conclusion

This has been a painful year for US equity investors, but the pain hasn’t been spread evenly among investors. Portfolios overweight in risky and losing companies were more affected than portfolios more weighted in companies with less leverage and with more positive cash flows. Even in some of the worst performing sectors, such as technology, the breakdown of companies, on the basis of earnings and cash flow, there is a clear advantage to owning older, lucrative technology companies rather than young companies. technologies that lose money:

Inflation: the disparate effects on corporate values

Whether these trends will continue to hold for the rest of the year cannot be answered without taking a position on inflation and the effects its fight will have on the economy.

  • If you think there are more surprises ahead on the inflation front and a recession is not only imminent but likely to be steep, returns for the first five months of 2022 will be a precursor to the same. thing, for the rest of the year.
  • If you think markets have largely or fully adjusted to higher inflation, betting on continued small cap and value outperformance is dangerous.
  • To the extent that there may be other countries where inflation is not the clear and current danger that it is in the United States, investing in stocks from these countries will provide better trade-offs between risk and reward. yield.

As I noted in my last article, once the inflation genie is out of the bottle, it tends to drive all other topics out of the market conversations and become the driving force behind everything from asset allocation to stock picking.

Original post

Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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