Here we discuss the basic principles to be followed when investing in the stock market in an inflationary environment

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MoneyVidya.com Investor Essentials:
How to invest in stocks when inflation is high
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Introduction
Periods of high inflation can create a difficult environment for investors, as well as creating
problems for the economy as a whole. In order to maximise portfolio returns, investors may need to
adopt a more active investment style and follow two maxims which would not normally apply in low
a inflation environment;
Firstly, investors should invest in companies whose earnings growth has the ability to offset the
inflationary effects on P/E ratios. These stocks are generally either those whose earngings are
naturally leveraged to inflation or are less mature stocks in less mature markets who have high
natural earnings growth.
Secondly, investors must be prepared to quickly rebalance their portfolios between an inflationary
and a deflationary strategy, when the economic environment innevitably changes.
The importance of focusing on earninings growth
The inflationary effect on P/E ratios is that they fall in times of high inflation. As the price of both
inputs and sales increases, profits generally rise in nominal money value without any improvements
being made in a company’s productivity or market positioning.
Because the monetary value of everything, including earnings is rising, over time earnings growth
which is a key factor in determining stock price, becomes more and more a product of inflation
rather than improvements in the underlying business.
Now you might think that all earnings growth is a good thing, but this is not the case. Investors
typically place less value on increased earnings which are caused by inflation, than growth coming
from business development. This is because an increase in the earnings generated by a company
which is caused by inflation does not neccessarilyt make it a more attractive investment, relative to
other investment opportunities. The growth in earnings is also not sustainable in the long term
because inflation is generally a temporary phenomenon.
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Investors are therefore reluctant to allow stock prices to rise in line with nominal (monetary)
earnings. This means that the real return on equities (after adjusting for inflation) often falls
becuase the rise in stock prices does not match the rise in the general price level. P/E ratios are
therefore downgraded in order to maintain the ratio between price and profit.
Because of the downgrading of P/E ratios, investors should avoid many large cap consumer
companies which would be natural choices under normal markeet conditions. The key sectors to
hold in an inflationary period are companies whose earnings are leveraged to inflation and therefore
can maintain or grow their P/Es. Energy and mining companies are generally safe bets and
obviously buying companies which sell commodities can also provide good returns, as can investing
directly in commodities themselves.
Outside of the commodity space, mid cap and small cap growth stocks are likely to outperform the
large cap indices as they have the potential to maintain the balance between genuine earnings
growth and inflationary earnings growth. This id because large mature companies which operate in
mature markets have far less scope for natural revenue expansion than less mature growing
companies who operate in growing maarket segments. The natural growth of these smaller stocks
can help protect the investor from the inflationary effect on stock prices.
Willingness to rebalance towards a deflationary strategy
The second rule of inflationary investing is being prepared to rebalance your portfolio towards a
more deflationary strategy when the economic environment changes. Since the second half of the
2oth century, high inflation has been seen as the primary economic enemy in the eyes of modern
policymakers. Many central banks have a specified inflation targets and modern monetary policy is
widely focussed on inflationary management. This means that whenever inflation is high, there is
always the liklihood of monetary tightening being used to aggressively slow the economy and keep
inflation in check.
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When the innevitable change in monetary policy occurs, the investing environment could begin to
change dramatically and investors should be willing to quickly rebalance their portfolios and adopt
a deflationary strategy once the monetary policy takes effect on the economy. This means that as the
economy begins to slow down in response to higher intest rates and lower money supply, investors
should start moving their equity investments out of commidty and growth stocks into low beta
defensive stocks such as food, tobacco and FMCG companies. Holding some zero coupon bondds in
the wider portfolio is also a good idea as a hedge against deflation.
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