According to John Buckingham, a value manager at Kovitz Investment Group and author of The Prudent Speculator stock letter, this has always been the case. He now anticipates a repeat performance. Part of the explanation is that inflation fears raise the rate on 10-year bonds, which has a negative NPV effect on growth stocks (described above).
According to the government, inflation increased at its fastest rate since 1982 in December. It was the third month in a row that inflation exceeded 6% on an annual basis.
However, there is another force at work. Companies with actual earnings might enhance profit margins by raising prices during inflationary times. Value companies are more mature as a group, which implies they have room to grow their earnings and margins. This attracts investors, who are drawn to those companies.
Growth names, on the other hand, are defined by predicted earnings, therefore they gain less from price increases.
“Because growth companies don’t produce money, they can’t expand margins,” Buckingham explains. “Employees are getting paid more, but they aren’t producing more money.”
When inflation is strong, value stocks historically outperform, according to a graphic from Buckingham.
Why are value stocks more resistant to inflation?
If you invest 100 in a value business with a price/earnings (P/E) ratio of 5x, for example, that multiple means your shares should produce 20 each year in profits, and thus you will’recover’ your investment after five years. A growth company, on the other hand, is likely to have a high P/E ratio, implying low earnings now, but growth investors are willing to pay up in the hopes of generating money in years 16 to 20, rather than the first five.
That makes the value business a’short-duration’ asset and the growth business a ‘long-duration’ asset in financial terms. Regardless of the fancy verbiage, the crucial practical lesson is that money now is worth more than money in the future in an inflationary climate. The more money is invested in the future, the less it is worth. As a result, in an inflationary environment, value, which sees investors repay their money sooner rather than later, is more appealing.
Investors, on the other hand, have been significantly less anxious about inflation than deflation during the last seven years or so. Prices of goods and services typically rise with time (that is, they inflate), thus 1 buys you less and less as you look further into the future.
Deflation, on the other hand, causes prices of goods and services to fall, so your 1 will buy you progressively more things or services the further out you look. In a deflationary economy, growth firms, or those with a long-term solid franchise, are valued much higher than value enterprises.
This is why growth companies, particularly high-quality companies with pricing power so-called ‘bond proxies,’ such as food, beverage, and cigarette companies have performed so well recently. It’s also why, if you feel inflation is on its way back and we don’t have an opinion on that, either way it would reverse a big chunk of value’s recent underperformance.
Do value stocks fare well in an inflationary environment?
It seems strange to be concerned about inflation during one of the sharpest and most severe economic downturns in our lifetimes.
However, given the Federal Reserve’s massive government spending and monetary policy, it’s something that many are thinking about as a potential risk in the not-too-distant future. The “concern” is that once the virus has been contained, the economy could overheat as a result of pent-up demand and government spending.
My initial take on this is that if we do get inflation as a result of all of this spending, it’s a good thing since it implies we’ve beaten the virus and are back to business as usual (if there is such a thing).
I’m not taking a victory lap here because I certainly didn’t expect inflation to reach nearly 8%. I hadn’t anticipated so many supply chain challenges as a result of high consumer demand.
And that piece wasn’t so much about making a macro call as it was about figuring out why value equities had fallen so far behind growth stocks in the years preceding up to the epidemic.
My conclusion was that more inflation was required for value stocks to outperform once more. Here’s how it looks:
Value has tended to do better during decades with above-average inflation and worse during decades with lower inflation, however this is not a perfect link. This was my original theory for why this happened:
Consider growth stocks in the same way that you would a bond. The purchasing value of your fixed rate income payments is reduced over time by inflation, which is why inflation is such a huge risk for bondholders.
The same can be said for growth stocks’ predicted future revenue or profit growth. Value stocks are likely to have cash flows that are already decreasing and will continue to do so in the future. As a result, higher interest rates should affect value equities less than growth companies, because the higher hurdle rate reduces the value of future growth.
Let’s put this notion to the test now that inflation has been rising for almost a year.
Since the beginning of 2021 through Monday’s closing, the DFA small and large cap value funds1 have outperformed the market and growth stocks:
During this inflationary period, value equities have excelled by a wide margin. So far, everything has gone well.
When inflation is greater, value tends to outperform for international companies as well:
It would be naive to believe that inflation is the only driver driving value or growth equities. Inflation has a part, but nominal growth is typically higher when inflation is high.
And sometimes value outperforms growth because growth values are too far off the mark.
Because I can’t forecast the future path of inflation (and I’m not sure anyone else can either), I’m not smart enough to predict whether value stocks will continue to thrive.
However, this serves as an excellent reminder of the significance of diversifying your portfolio across economic cycles.
Since reading Ray Dalio’s The All Weather Story a few years ago, this chart from the book has stayed with me:
Because we don’t know when or why the economic environment will change, the aim is to combine investments that work under different economic regimes together.
No one predicted a major inflation/economic growth increase in 2019, yet that’s exactly what we’re experiencing right now.
In a long time, we haven’t had to deal with a rising inflation/increasing growth economy.
Value stocks have been behind for some time, but perhaps they just needed the ideal circumstances to shine.
I’m not predicting that value investment will continue to outperform. I honestly have no idea.
I’m not sure how much of the inflation story has already been priced into value and growth equities.
I’m not sure if the Fed will be able to keep inflation under control.
I am aware that building a long-term portfolio necessitates diversity of techniques that may thrive in a variety of market and economic conditions.
1Full disclosure: DFA funds are used in several of my firm’s client portfolios, and I own some of these funds.
When interest rates rise, why do value stocks outperform?
- Because of their long-term potential, growth stocks are likely to beat the market over time.
- Value stocks are supposed to trade at a discount to their true value, implying that they will produce a higher return in theory.
- The topic of whether to invest in growth or value stocks must be considered in the context of an individual investor’s time horizon and the level of volatility (and consequently risk) that can be tolerated.
Inflation favours whom?
- Inflation is defined as an increase in the price of goods and services that results in a decrease in the buying power of money.
- Depending on the conditions, inflation might benefit both borrowers and lenders.
- Prices can be directly affected by the money supply; prices may rise as the money supply rises, assuming no change in economic activity.
- Borrowers gain from inflation because they may repay lenders with money that is worth less than it was when they borrowed it.
- When prices rise as a result of inflation, demand for borrowing rises, resulting in higher interest rates, which benefit lenders.
What happens to the stock market in a hyperinflationary environment?
Inflationary periods, such as those seen in the United States in the late 1970s and early 1980s, are generally not considered beneficial economic times, as prices often rise faster than salaries. Hyperinflation is considerably worse because it is accompanied by a sharp increase in prices. The most well-known instance of hyperinflation occurred in Germany shortly after World War II, when a loaf of bread was said to require a wheelbarrow full of paper money. Stock prices, like all other prices, will soar under hyperinflation.
Are stocks a good way to protect against inflation?
You might not think of a house as a smart method to protect yourself against inflation, but if you buy it with a mortgage, it can be a great way to do so. With a long-term mortgage, you may lock in affordable financing for up to three decades at near-historically low rates.
A fixed-rate mortgage allows you to keep the majority of your housing costs in one payment. Property taxes will increase, and other costs will climb, but your monthly housing payment will remain the same. If you’re renting, that’s definitely not the case.
And, of course, owning a home entails the possibility of its value rising over time. Price appreciation is possible if additional money enters the market.
Stocks
Stocks are a solid long-term inflation hedge, even though they may be battered by nervous investors in the near term as their concerns grow. However, not all stocks are equivalent in terms of inflation protection. You’ll want to seek for organizations with pricing power, which means they can raise prices on their clients as their own costs grow.
And if a company’s profits increase over time, so should its stock price. While inflation fears may affect the stock market, the top companies are able to weather the storm thanks to their superior economics.
Gold
When inflation rises or interest rates are extremely low, gold has traditionally been a safe-haven asset for investors. When real interest rates that is, the reported rate of interest minus the inflation rate go below zero, gold tends to do well. During difficult economic times, investors often look to gold as a store of value, and it has served this purpose for a long time.
One effective way to invest in gold is to acquire it through an exchange-traded fund (ETF). This way, you won’t have to own and protect the gold yourself. Plus, ETFs provide you the option of owning actual gold or equities of gold miners, which can provide a bigger return if gold prices rise.
How can I plan for inflation in 2022?
With the consumer price index rising at a rate not seen in over 40 years in 2021, the investing challenge for 2022 is generating meaningful profits in the face of very high inflation. Real estate, commodities, and consumer cyclical equities are all traditional inflation-resistant assets. Others, like as tourism, semiconductors, and infrastructure-related investments, may do well during this inflationary cycle as a result of the pandemic’s special circumstances. Cash, bonds, and growth stocks, on the other hand, look to be less appealing in today’s market.
Do you want to learn more about diversifying your investing portfolio? Contact a financial advisor right away.
What effect does inflation have on interest rates?
Inflation. Interest rate levels will be affected by inflation. The higher the rate of inflation, the more likely interest rates will rise. This happens because lenders will demand higher interest rates in order to compensate for the eventual loss of buying power of the money they are paid.