2 Important Metrics to Tell If The Companies You Own Are Inflation Proof
Why Inflation is So Dangerous For Investors and Businesses
We are living in a world grappled with high inflation. Every few days, there are news headlines of prices of goods rising. We are worried about the impact of inflation on our cost of living. How will our investment portfolios hold up in this inflationary environment?
How Inflation Affects Businesses?
Imagine we own a chain of supermarkets. We sell $100M worth of items each year. Each year, we pocket $20M of that $100M as profits.
So, we have:
Annual Revenue = $100M
Costs = $80M
Annual Profits = $20M
Without inflation, let's assume a repeat of this performance each year. Each year, we'll get to take out $20M of cash from our supermarkets. That's a steady eddy reliable source of income.
How will this change if inflation is 10% per year instead? Let's say our customers love our products. So, if inflation runs at 10% per year, let's say we'll be able to raise the prices of our goods at 10% per year, without a decrease in demand. This is where we have pricing power.
So, next year, our price increases will cause our revenues to grow 10%. We'll make $100M * 1.1 = $110M. But of course, our costs (e.g. rent, cost of goods, employee salaries) will also grow 10% . That's what inflation does. So, our costs are now $80M * 1.1 = $88M.
That gives us $22M in profits, a 10% annual increase. This doesn’t seem so bad, as our profit has increased in line with inflation. So what’s the issue here?
Are We Creating A Problem Out Of Nothing?
Not quite. The problem here is capital. Our supermarkets need inventory and fixed assets. When inflation is high, the cost of buying new inventory and fixed assets keeps growing.
Whether we like it or not, we'll have to keep injecting new capital into our supermarkets to pay for inventory and fixed assets. Every dollar of new capital we put in is one dollar that's not available for us to take out of the business. That’s where the costs start to slowly add up.
To better illustrate this point, let's use some numbers. Suppose our supermarkets have $30M of Capital that we've put into them. That's $0.30 of Capital for every $1 of Revenue. On this $30M investment, if inflation is zero, we'll take out $20M in profits each year. That's gives us around 66.66% return. Pretty good!
But when inflation is 10% per year, that $30M of capital will likely increase. If we assume that our ratio of "$0.30 of capital for every $1 of revenue" remains roughly the same, that means capital also has to grow at 10% per year.
So, next year, we'll need $30M * 1.1 = $33M of capital. The additional $3M of capital has to be taken out from our profits. That is, of our $20M in Profits, we'll have to re-invest $3M back into the business, leaving us with only $17M to take out.
That's the problem with inflation. The cash we can take out of our business is no longer $20M per year. It's more like $17M per year, representing a 15% drop, even though inflation itself is only 10%!
What makes things worse is that this $17M is "less valuable" in dollar terms, no thanks to inflation. After adjusting for inflation (assuming 10%), it's only worth $17M/1.1 = $15.45M. By contrast, the $30M we put into our business was in last year’s more valuable dollars.
So, on our $30M investment, we get to take out about $15.45M per year in inflation adjusted terms. That's a return of 51.5%. While still a decent number, inflation has brought down our real return from 66.66% to 51.5%.
However, all this is under one very big assumption- that our business has pricing power. If not, our real returns will drop even more.
How To Invest for Inflationary Times
When investing for inflationary times, we have to select businesses that exhibit 2 characteristics:
1) Pricing Power
When companies can raise their prices without losing its customers, that’s where they have an edge over its competitors.
2) Capital Light
Capital light businesses do not eat up a big chunk of its owners' profits in re-investments each year. This allows business owners to continually re-invest into the company’s growth.
It is common to see the stocks of big retailers like Target, Walmart, Home Depot being hit HARD when inflation runs hotter than expected. Retailers typically need to keep a lot of inventory on their shelves, which requires capital.
Summary
This is how inflation reduces returns for investors and business owners. Inflation fears create a volatile stock market. Only those who survive volatility in the short term can build wealth in the long term.