Vol. 1, No. 1
Vol. 1, No. 1
Inflation and Asset Class Returns, Stock Valuation Rundowns, and a Deep Dive on My Best Idea.
Welcome to Valuabl - a fortnightly newsletter for value investors with in-depth research, stock valuation rundowns, and deep dives on my best ideas.
In Today’s Issue:
Inflation and Asset Class Returns (6 minutes)
Stock Valuation Rundowns (4 minutes)
Deep Dive on My Best Idea (9 minutes)
1/ Inflation and Asset Class Returns
Over the last few weeks, we’ve seen central bankers, executives and public figures increasingly suggest that inflation will be less transitory than they had initially suspected. Who could ever have guessed?
When you have a global pandemic that shuts down global supply chains and kills supply, but you simultaneously stimulate demand, doesn’t it seem bleedingly obvious that inflation will result? However, I don’t want this piece to be about the mechanics of inflation (does anyone really know); instead, I want to look at history and see which asset classes have performed well and poorly during periods of rising inflation.
Inflation and asset class performance
To get an idea of how to position portfolios for a future with potentially higher inflation levels, the natural place to start looking is in the past — to study how different asset classes performed in different inflationary environments.
I compiled return data for two different debt grades, three equities styles, and two ‘real’ assets from 1950 to 2020. The assets I chose were:
Debt: Investment Grade (US10Y T.Bill), Speculative (Baa/BBB+ Corporates).
Equities: Market (S&P500), Small-Cap (Small Minus Large Factor), Value (Value Minus Growth Factor).
Real Assets: Land (Real Estate Prices), Commodity (Gold Price).
You can view the worksheet online here or create a copy of it to do your own analysis by clicking here.
The following chart summarises the results and demonstrates a statistically significant positive correlation between nominal ‘real’ asset returns and inflation, a negative correlation between debt and average equity securities and inflation, and a small positive relationship between the value and size factors and inflation.
Looking at the data and results more closely, I found the following:
Inflation has been historically low: The average inflation rate from 1950-2020 was 3.45%, but it was 1.72% over the most recent decade. Moreover, this data is not just skewed by the high inflation 1970s as when we look at the medians we get 2.82% (1950-2020) and 1.64% (2020-2020). The low inflation we’ve become used to is not the norm.
Tangible asset returns and inflation are correlated: Nominal returns on tangible assets have a statistically significant relationship with inflation. Nominal Real Estate price returns correlated +0.39 with inflation rates, and Gold Price returns correlated +0.48.
Gold outperformed during high inflation: During the high inflation period of the 1970s, Gold was the best performing asset.
It’s not just the magnitude of inflation that matters; it’s the direction too:
If inflation is rising, Gold outperforms, but fixed income underperforms: During periods of rising inflation, Gold Prices had a +0.42 correlation, while US10Y T.Bills correlated -0.26.
If inflation is declining, Gold underperforms, but fixed income outperforms: During periods of reducing inflation, Gold Prices had a -0. 42 correlation and US10Y T.Bills correlated +0.26.
Small/value companies tend to outperform large/growth: There was a negative correlation between inflation and returns on the S&P500, but there was a slightly positive correlation between small/value equities and inflation. None of these is statistically significant, although it does suggest that small/value outperforms average equities during higher inflationary periods.
If inflation is picking up, tangible assets become worth more and interest rates rise, reducing fixed income value. If inflation is declining, tangible asset values decline and interest rates come down, increasing fixed income value. This result goes some way to explaining the extraordinary fixed-income bull run we’ve had over the past 40 years as inflation and interest rates have continually declined.
The effects of inflation on intrinsic value
Let’s unpack this a little bit further and decipher the impact of inflation on the drivers of intrinsic value. Does inflation raise or lower value? Well, the above data suggest three immediate things:
Commodity businesses should become more valuable with rising inflation.
Debt securities and assets reliant on debt refinancing are worth less as inflation rises.
The relationship between equities (whether value/growth, small/large or the broader market) and inflation is complicated.
The first two results are intuitive. So, why is it that inflation has, historically, had a mixed effect on equities? Let’s break it down by recalling that there are two sides to the valuation equation: On the one hand, you have the Free Cash Flows, and on the other, you have the Discount Rate.
All else being equal, higher inflation will push Discount Rates higher because rising inflation leads to higher interest rates — this is the obvious part. What is less obvious is that higher inflation also increases Free Cash Flows on average. Why? Higher inflation means:
Businesses raise prices faster which leads to higher revenues and growth. Moreover, if real economic growth remains unchanged, higher inflation will lead to higher stable/mature growth rates. Raising FCF.
Companies with First-In-First-Out (FIFO) accounting will increase profit margins slightly. The longer the delay between the recorded good’s cost and the sale date, the more significant the inflation benefit. For example: If inflation is 0% and my business buys its goods for $8 in January and sells them for $10 in July. My Gross Margin is 20%. But, if inflation is 10% p.a., then my business would buy the goods for $8 in January and sell them for $10.50 in July (5% price inflation). My Gross Margin is now 23.8%. This is an extreme example, but it illustrates the point. Raising FCF.
Businesses with large, long-term asset bases will see Returns on Capital rise because inflation pushes up revenues and profits in absolute terms. In contrast, assets are held on the balance sheet at historical cost (Raising FCF). But, reinvestment requirements also rise because the future cost/price of replacing assets increases compared to Deprecation and Amortisation schedules (Lowering FCF).
These are not hard and fast rules applicable to every company. Still, they illustrate that inflation has a mixed effect on average equity intrinsic values and demonstrate the importance of linking growth, reinvestment, and capital costs.
What does this mean for investing in a rising inflationary environment? The first and the most obvious idea is to get out of fixed income debt securities. Holding Government Bonds or Corporate Paper is a sure-fire way to have a lousy time if inflation continues to rise. The second idea is to focus on tangible assets and their producers (miners with substantial developed reserves, for example). The third idea is to avoid traditional large growth stocks and seek out undervalued smaller companies. But, how to find them? That’s the billion-dollar question.
2/ Stock Valuation Rundowns
Over the past fortnight, I have valued five companies. Four of them seem overvalued, and one seems modestly undervalued. As per the new format, I will outline each valuation but focus primarily on delving into the details of the best opportunity.
If you’re already a paid subscriber, don’t forget to post your stock valuation requests here.
StoneCo, Ltd. (NASDAQ: STNE) - Valuation on 5th October
StoneCo (US$10.24b market cap) is a Brazilian business in the rapidly growing Digital Payments Space. Acquisitions and marketing will drive their expansion into new markets and services. Thanks to the business’s operating leverage, this increased scale will benefit margins (which will become Mastercard-esque). As a Brazilian business, they face inflation and country risk, and their low credit rating (Ba2) drives a fair chance of distress.