Inflation refers to the slow increase in prices of goods and services, which eventually leads to a loss of purchasing power of money over time. This impacts both consumers and businesses, as the erosion of money affects entire industries and not just specific products or services. The rise in prices across sectors can push up the prices of essential items such as groceries, utilities, petrol, and materials.

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What is Inflation?

To better understand inflation, consider the following example. When I was in primary school, I could buy 20 red frogs for 20 cents. However, recently, I purchased a bag of 25 red frogs for $2.50 on special. This means that the value of a red frog lolly has increased by over 900%, from 1 cent to 10 cents. Such an increase in prices is what we call inflationary impact.

Although some inflation can be healthy for the economy, it can become harmful when it reaches high levels. In recent years (2022-2023), Australia experienced 7% inflation, and the US peaked at 9.1%. Such high levels can negatively impact the entire economy, including stocks, investments, and the cost of living.

The Consumer Price Index (CPI) and the Producer Price Index (PPI) are the main measures used to track inflation. The CPI tracks changes in what consumers are paying, while the PPI tracks what producers are receiving.

Inflation is becoming a growing concern for many economies, not only because of its rise but also because its staying high. For example, in Australia, the cost of living has skyrocketed, leading to a housing crisis and difficulties for many people in keeping up, despite high employment and wage growth.

Investors need to be aware of inflation and its impact on their future investments and learn how to combat it.

What causes inflation?

Inflation can be attributed to two main factors: demand-pull and cost-push . Simply put, inflation is primarily driven by the forces of supply and demand.

Demand-pull inflation occurs when the demand for goods and services within an economy exceeds the economy’s capacity to supply them. For instance, when a global conflict results in a shortage of wheat, it can cause an increase in the price of wheat due to the excess demand. Demand-pull inflation can further worsen if, despite farmers increasing their wheat production, the supply still falls short. Issues in logistics and supply chains can also contribute to demand-pull issue.

On the other hand, cost-push inflation arises when the cost of inputs used in the production process increases. For example, if there is a shortage of minerals that make up lithium batteries, the price of the commodity goes up, resulting in higher battery prices.

This increased cost is then passed on to businesses and consumers. Companies are forced to increase prices to cover the increased costs, and the reduced supply of goods and services available in the economy due to increased production costs also contributes to cost-push inflation.

Businesses have no choice but to pass on input cost increases to their customers to maintain their profitability. Investors should be aware of the cost pressures faced by companies when considering investing in them.

Inflationary impacts on the stock market?

Higher inflation is seen as a negative for stocks because it usually increases borrowing costs, higher costs of materials and labour, and pessimism around earnings growth.

When inflation occurs, companies often have to pay more for input materials. To maintain their operating margins, they usually pass on the additional costs to customers. This leads to rising prices, which can negatively affect customer relationships, and trust, and encourage competition as consumers search for better prices.

Someone somewhere must pay for higher prices within the economy.

Rising prices of goods and services can create uncertainty in the markets. Companies face uncertainty in earnings expectations and profits as margins decrease and spending is reduced. This impacts investor confidence, leading investors away from stocks, especially growth and higher-risk investments, and towards safer alternatives like value stocks or bonds.

Inflation affects the stock market in several ways, one of which is through fiscal policy. Governments may increase the interest rate to make borrowing more expensive. The goal is to bring inflation down to sustainable levels, which can be achieved by contracting spending in the economy. Increasing the interest rate adds pressure on consumers to manage their households more efficiently and curb unnecessary spending, thus managing the supply and demand in the economy.

This creates two issues for the stock market. Firstly, increased interest rates bring higher returns on fixed-interest accounts, bonds, and bank deposits. Investors often prefer safer financial instruments with higher returns, leading them to pull money out of equities.

Secondly, the increased interest rates add pressure to companies with leverage. Their cash flow and balance sheet strength are of vital importance, and companies must spend more on interest payments which can strain operational margins, leading to a riskier outlook for investors.

Investing to combat the effects of Inflation.

When investing during inflationary times, particularly as an active stock picker, it is essential to focus primarily on the underlying business. To do so, asking the question ‘How could inflation challenge this business model?’ is the best approach.

It is crucial to examine balance sheet strength, as heavily leveraged companies may incur increased repayments that can strain free cash flow. Therefore, it is important to look for companies with healthy balance sheets and low to manageable levels of debt.

While a business with reasonable performance may carry debt, it can be squeezed very quickly with a rise in interest rates. Hence, investors should look for companies that manufacture or produce goods and services and examine their supply chain to determine the possibility of an increase in costs. This can help investors look ahead at what may occur for a particular business.

Investors should also examine a company’s competitive advantage, particularly its pricing power. Does the business have a brand, service, or strength within the market to increase costs without damaging customer relationships? If a company needs to pass on costs to customers but has no MOAT, this can negatively impact the company.

During inflation, value stocks usually take centre stage as investors move out of growth stocks and uncertain expectations to companies that can sustain themselves through the cycle.

Diversifying can be an essential strategy to implement. In higher interest rate environments, fixed interest and bonds become favourable because investors can get a reasonable return with minimal risk.

Rather than focus on asset allocation, diversifying or inflationary hedges like Gold and Cash, I think investors need to focus on the company. Rather than say Value is better than Growth, investors should focus on answering the first question. How will inflation impact the underlying business?

Inflation-Proof Stock selection checklist:

Considering other asset classes such as allocating more to bonds, fixed interest and REIT’s is a standard approach to combat inflationary concerns. However, as Stoic Investors we remain active in stock selection. Here are a few questions I ask myself when considering companies during these times. With no bias towards Value or Growth, ask these questions no matter the approach to investing you have. Not all questions will suit a business.

The Question?	Areas to look at:
✅ Will this company benefit from inflation?	Is this company set to be a benefactor of higher inflation? Perhaps a cyclical now in favour?
✅ Will rising interest rates impact this business?	Look at the income statement, what are the interest expenses? Will a rise in expenses impact margins? How much increase is it?
✅ Will cost conscious consumers still pay?	Is it a consumer staple/discretionary? Will consumers drop this as household expenditure decreases? Do they still need this product/service?
✅ Will there be an issue in the value chain?	How does the value chain look? Will changes further down impact the company at the top?
✅ Can a supply-chain issue impact the business?	Look at how supply and demand work, will a strain on demand cause challenges with logistics? Will the company face delivery concerns?
✅ Can this company increase its costs?	Look at the impact increasing prices has. Does the company have a competitive advantage to raise costs? Pricing Power? Sticky clients? Brand?
✅ Is there margin impact from higher costs?	Is an increase in input costs going to cause a strain on margins? Or does it have to be passed on?
✅ Is this a temporary positive for this company?	Look for traps, sure a cyclical could come in favour for a season but avoid temporary benefactors.
✅ Can this company gain market share?	Is this business positioned better than competitors to take advantage?

In Summary…

It is important to consider market conditions when developing an investment philosophy. This will help you align your strategy to suit the prevailing conditions. It’s not about changing your investment style; it’s about strengthening your existing convictions and becoming more methodical in your investment process.

To beat it over the long term, it’s best to invest in companies that can compound your capital at higher rates over a long period of time. If you pick the right company with high returns of capital that is expanding into a large market, then that company can outpace inflation.

Another important factor when considering investing is how inflation impacts overall returns.

Many investors only work off nominal returns, which can provide a smoke screen of true value. However, it’s important to consider the real rate of return. For example, if you have a portfolio that averages a 7% annual return, that is the nominal rate. The real rate of return or the Inflation-Adjusted rate of return is less. Let’s say inflation is trailing at 4%; the real rate of return on your portfolio is 3% (7% – 4%).

That’s why I focus on looking for companies that can compound at higher rates of return and hold them. This is because if you’re holding a portfolio of stocks that return, let’s say, 12% annually as the nominal rate of return, then the inflation-adjusted return will be 8% (12% – 4%). 8% compounded over decades will do just fine.

Considering inflation when looking at returns is necessary to create long-term wealth. Finding those compounders that can help investors beat inflation is key.