Inflation can be tricky to understand at times. When there is too much of it, that’s not good but also when there is not enough of it. There are inflationary and deflationary cycles. Although we let economists and central banks worry about reporting and controlling inflation, we only care about how it impacts us and the businesses we invest our money in. So how does inflation affect investments?
Inflation is on the rise
At the time of writing at the end of 2021, inflation is in the news more and more. Supply chain pressures and ridiculous amount of money that North American governments have printed during COVID to support spending all result in record levels of inflation. Prices are on the rise.
This is clearly visible in this CPI chart. Just take a look at that spike from 2020 to 2021.
We view all our investments as investments in some form of a business. We buy small pieces of companies with stocks, but even when we talk about real estate investment properties or digital assets like websites we view them as separate small businesses. One sells housing, and the other sells products or services online.
So the real question is, how does inflation affect our businesses?
Inflation is not just prices going up. It also means that the value of money we receive from our portfolio companies and real estate or online businesses goes down. So to avoid the negative impacts of inflation, we must increase cash flows at the same rate.
Our businesses can offset these effects if:
- Our businesses can reduce costs and increase profitability
- They can pass the price increase to the consumer.
Note that inflation or deflation can happen at any time in specific industries without raising the overall consumer price index or CPI ( https://www.bls.gov/cpi/ ). Great example of this is housing market that is not included in the CPI but is very real for real estate investors.
Can a business pass along price increases?
How does inflation affect investments in businesses that can’t change prices easily? If the companies we own can pass on price increases to our customers, they can offset inflation. Note that any business can increase prices at any time, that is not the problem. Companies must be able to raise prices without losing sales; that is the challenge. Not all markets will allow prices to increase.
Let’s take rental property as an example. If electricity or maintenance costs go up significantly, but the local government controls rents, you cannot pass these costs to your customers, in this case, your tenants. Also, you might not want to for ethical reasons.
Think about the companies you own in your portfolio as well. Do they have the ability to change pricing without losing sales? Are they allowed to change their prices freely? If the company sells goods that are not seen as necessary, this type of business will suffer during inflationary periods. If they try to pass prices on to consumers, consumers buy less of their goods.
Can a business reduce costs?
Look at a business cost structure. Are most costs fixed or variable? Businesses with high fixed costs, the ones that need to reinvest money into assets like machinery constantly, will not fair well during inflationary periods.
What will your competitors do in response?
Passing on price increases and cost management must not be viewed separately. Economists love to analyze decisions with the assumption that everything is done in isolation. The real world is different. Businesses don’t exist in a vacuum. Your business might want to pass price increase to your customer, but if your competition has a better cost structure and can reduce costs without changing prices, guess what, they will gain market share from you. So even if, in theory, you can pass the costs, you have to consider your own and your competitor’s cost structures.
Consider capital-expenditure requirements of a business.
If the business requires a lot of capital to grow, like a factory expanding or you increasing the number of rental properties, inflation increases the cost of such growth. Keep in mind that if the business made these investments in the past, the value of those investments has gone up as well. So your rental properties have appreciated as an example, but expanding to new properties is now more expensive.
How inflation affects investments in debt-heavy companies?
Common thinking goes that inflation is good for your debt. That is true if the debt obligation is long-term and doesn’t have to be refinanced. Your debt loses value with inflation which is a good thing, but inflation typically causes interest rates to rise. Remember, banks also experience cost increases, and combined with governments trying to stop inflation, rates go up. So businesses that have low debt will actually be better off.
This brings us to the principal risks of inflation: Rising wages and rising interest rates.
Retail businesses will suffer as wages go up and they have to employ a large number of people.
Rising Interest Rates
As we mentioned before, higher interest rates increase the cost of borrowing, and when debt is refinanced, that causes an increase in interest expense. Higher interest expenses reduce overall earnings. Stocks tend to underperform during such periods as their earnings decline unless companies can protect themselves from inflation.
When thinking about how does inflation affect investments, think about cash flows and how well the businesses you hold can sustain their cash flows in real terms.
If you are looking for a portfolio idea that performs well during inflationary periods, check out Ray Dalio’s All Weather Portfolio or David Swensen Portfolio.