Equities and inflation: a little theory

We hear a lot about the follies of holding cash during inflationary periods, but why are equities considered a hedge?

With UK inflation hitting a 30-year high and the nation in the grip of a cost of living crisis, price rises are on everyone’s mind, including investors.

When it comes to stocks and inflation, the narrative tends to focus on which sectors or types of firms stand to benefit directly from increases in raw materials. Or which companies have the pricing power to pass on cost increases.

Invariably the spinning bottle settles on commodities, commodity stocks, or banks.

And there’s nothing wrong with this view. Commodity price increases will boost sales for miners, and rate rises should feed into better profits for banks.

But for some investors, commodities and long-term investing don’t go hand-in-hand. How can anyone really know what the price of oil, gold or copper will be in five years?

The answer is they can’t. There is a plethora of unpredictable variables that impact commodities. And if history is any guide, prices tend to mean revert as supply adjusts to demand.

This doesn’t mean a view is right or wrong, it just means it's likely to be a bit of a guess. 

So instead of being just another gold bug in the room, we thought a dip into some stock economics might freshen things up and help guide investors in their hunt for inflation protection. 

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Why are stocks considered an inflation hedge?

The theory is pretty simple. Most firms are able to increase prices as their costs go up. If sales and costs both increase by the same amount, then profit goes up too and margins stay the same. 

And a like-for-like increase in sales and costs has the same impact on all businesses, regardless of their level of profitability. 

This way at least the real level of profit, i.e. after adjusting for inflation, stays the same. Contrast this with cash, whose real value falls when general prices increase.

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Margins are a real buffer

In the real world, though, not all companies can raise prices enough to fully offset cost increases. In fact, for competitive or strategic reasons, they may not want to. 

And this is where profitability matters. Highly profitable businesses can shoulder cost increases without fully passing them along to customers and still grow the bottom line. 

Consider two companies, both with sales of £100 but one with costs of £40, the other £80.

If costs increase by 10% for both but they are only able (or choose) to raise prices by 5% one will still grow profits and the other will see a fall.

Company A £100 - £40 = £60, £105 - £44 = £61

Company B £100 -  £80 = £20, £105 - £88 = £17

The highly profitable business has managed to absorb the cost increase and still improve profit, while the less profitable business has seen its bottom line fall by 15%.

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Fixed for protection

It’s also important to take a closer look at the make-up of a company's cost structure. Most companies have a mixture of fixed and variable costs. Variable costs rise or fall with the level of sales. 

Raw materials and other costs of sales are examples where you can’t sell more stuff without a bigger cost bill. It's these costs that are likely to be impacted by inflation. Wages can be thrown into this bucket too.

Fixed costs, on the other hand, tend not to be impacted by the level of sales activity. A fixed rent expense is an example, which is usually locked in for a period of time. These costs should be partially shielded from inflationary pressures, at least in the near term.

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Piecing it together

The bottom line is highly profitable businesses are better positioned to weather an inflation storm than those operating on wafer thin margins. They have a buffer to soak up cost pressures and don’t always have to pass prices along to their customers. 

We have no issue with miners or banks, but longer term thinkers might want to throw sustainable profit margins and fixed costs into their selection mix too. 

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