Fundamental Investing and Inflation Risk - A Structural and Factorial Approach

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"I remain undisturbed concerning the fluctuations of share prices at the stock exchange [on 16 November 1923]. Generally speaking, most values have turned to become worthless compared to the dollar." (Victor Klemperer, 1996, p.758)

Inflation and the fight against it have not been in anyone's mind since the last decade. The tail risk of higher inflation is insignificant but rising. However, I believe that understanding the risk of inflation and its impact on securities and companies is vital. Inflation reduces the purchasing power of the currency and promised bonds' coupon and principal payments. The impact on equities is unclear and subject to misunderstanding by even seasoned practitioners.

The age-old wisdom is to invest in equities for hedging inflation risk. It is assumed that inflation will create reflationary conditions that would improve the economy's output, hence its earnings. This is certainly true if reinvestment capital, profitability and demand are inelastic to inflation, which is an absurd way of observing financial interdependencies. Here are a few items that could influence the relationship between inflation and earnings growth -

-> Inflation and its impact on capital re-investment cost.

-> Inflation and expense variables, such as labour and raw material.

-> Inflation and consumer elasticity to inflation.

-> Inflation and the firm's pricing power.

The earnings growth will be a function of these and many other factors.

To understand the impact of inflation on firms' prospects, we need a theory to take a closer look and empirical evidence to back the theory. The theory of endogenous operating growth is a sound theory to understand the role of different factors on a company's growth.

Historical and estimates of a company's growth are usually an exogenous variable that affects the value but is divorced from its operating details. The sound approach would be to make growth a function of how much a firm re-invests for future growth and profitability.

The company's prospects defined by growth in its operating income are a function of reinvestment rate and capital return.

The equation could further be broken down in the following way -

High Operating income growth could be due to the following reasons -

-> Growth due to the high re-investment rate.

-> Growth due to the high-profit margin.

-> Growth due to high sales to invested capital.

For comparison purpose, let's assume there are three companies -

-> Company A has a reinvestment rate of 10% at t-1; an operating margin of 1% at t; and invested capital to the sale of 1% at t; will have an operating profit growth of 10% at t.

-> Company B has a reinvestment rate of 1% at t-1; an operating margin of 10% at t; and invested capital to the sale of 1% at t; will have an operating profit growth of 10% at t.

-> Company C has a reinvestment rate of 5% at t-1; an operating margin of 5% at t; and invested capital to the sale of 2.5% at t; will have an operating profit growth of 10% at t.

A naive investor could conclude that all three companies are identical. It doesn't matter the quality of growth, but the 10% (absolute value) growth matters the most. He would pay the same price for all companies.

An intelligent investor knows that those three elements have their own risk, and a certain type of quality of growth is of higher worth at a given point in time. I will get back to the quality of growth after discussing the types of risk affecting these factors (fundamental ratios) and the sensitivity of these factors on operating growth.

The sensitivity of these factors on operating growth is as follow:

The best firm will be the one with a high return on capital and a mid-high reinvestment rate.

Through this sensitivity, we can formulate the following types of firms:

Backtest

For empirical research, I have performed backtesting by building portfolios based on a permutation of the following factors: reinvestment rate, OPAT margin and sales to invested capital using 1500+ (or available securities before the 1980) US public firms.

For example,

-> Portfolio HHH at time t: A firm with Reinvestment rate, OPAT Margin and Sales to Invested Capital above 75th percentile relative to the universe of stocks at time t; returns are recorded t+1 portfolio is rebalanced at t+1 (every year).

-> Portfolio LLL at time t: A firm with Reinvestment rate, OPAT Margin and Sales to Invested Capital below 25th percentile relative to the universe of stocks at time t; returns are recorded at t+1, and portfolio is rebalanced (every year).

To demonstrate how fundamental of firms affect their prospects, let us take two portfolios and see how their stock performed in the last 30 years -

-> HLL - Very High Risk/Low Reward (see 2nd row in the table above)

-> LHH - Average Risk/High Reward (see 6th row in the table above)

Source: Holocene, Compustat & CRSP

Another set of examples:

-> LHH - Average risk/high reward (L is below 25th percentile) - Less risk to liquidity or reinvestment risk.

-> HHH - High risk/high reward (H is above 75th percentile) - High risk to liquidity or reinvestment risk.

Source: Holocene, Compustat & CRSP

The high reward and high risk of HHH vs LHH can be observed if we see the returns on these portfolios before the 2008 crisis. The 2008 crisis was really bad for firms that relied on re-investment to generate growth.

Source: Holocene, Compustat & CRSP

For your curiosity, here is the backtest result of all the portfolios mentioned in the table above.

Source: Holocene, Compustat & CRSP

Inflation Risk

Inflation has not been a problem since the 1980s. The trend has been downward, and recently the economy has become deflationary.

Source: Holocene and World Bank

During Inflation, companies with high sales to invested capital + high re-investment rate + high margins will see value destruction. As the prices rise, profits will be challenged due to a rise in commodity prices and a rise in wages. Also, the cost of reinvestment will rise, and the growth rate of operating income will reduce.

On the other hand, firms with low reinvestment rates, low margin and low sales to invested capital (the worst portfolio in the table above) will be resilient and protect value during such a time. It is because these companies have already put capital and require very low reinvestment. Also, they don't have a very high margin to see massive compression.

Source: Holocene, Compustat and CRSP

In conclusion, high-quality companies with low re-investment needs outperform in the long run, but the outperformance fades during the inflationary period. The blog post takes a theoretical and historical approach to make this conclusion. It is not a scientific truth, but views formed about the future scenarios on a knowledge of past experience.

The Notgeld (Germany)