Invest in high quality businesses

As an investor,the objective is to increase the long-term purchasing power of capital invested. Inflation is a serious threat to investors as it chips away the realized investment returns. For an individual,inflation affects value of real returns as also the consumption pattern. The rate of inflation is important as it represents the rate at which the real value of an investment is eroded and the loss in spending power over time. With this idea in mind,investors should review investment returns that are equal to or greater than inflation.

Fixed Income: A inflationary environment makes investing particularly challenging in fixed-income instruments. The impact of inflation in fixed-income securities is two pronged: (a) the purchasing power of interest received declines (b) inflation erodes the value of principal on fixed-income securities. The real interest rate is more indicative of the growth in the investor’s purchasing power,calculated as nominal rate minus the rate of inflation. Thus,if a bond has a nominal interest rate of 10 per cent and inflation is 8 per cent,the real interest rate is 2 per cent. Inflation seriously impacts people living on fixed income – for e.g. retired people with fixed pension. It directly impacts their ability to buy goods when the prices rise,and thus discourages savings when real interest rates are close to zilch – effectively meaning that the money is worth more presently than in the future.

Equities: Historically,equities have displayed a negative correlation to inflation over a short to medium term horizon. Essentially,high inflation increases uncertainty about the economy,leading to lower earnings forecasts for companies and lower equity prices. In the long-term,however,select equities are better positioned to do well in an inflationary environment – the caveat here being selection of businesses,since many are negatively impacted by high inflation and the resultant deterioration in macroeconomic scenario.

Choosing stocks

Businesses with pricing power: Among the businesses which are better positioned to withstand an inflationary environment must have two characteristics: (a) the ability to increase prices rather easily without impacting volume growth or market share [b) the ability to accommodate growth without significant investment of capital. The ability to increase prices would depend on moats surrounding the businesses which either is on account of strong brands,high entry barrier,franchises which cannot be easily replicated,etc.

Businesses which cause inflation: There are few businesses which do periodically benefit from high inflation. Many of these are in the commodity space. For e.g. oil companies would be among the best bet in current high oil prices. However,care should be taken while investing in these businesses given the limited pricing power and also many of these need constant capital to grow. Nonetheless,as a hedge against inflation,superior commodity businesses,which have globally competitive cost structure,would do well.

To sum up,given the structural growth drivers of the Indian economy and the resultant demand pressures along with budget deficits we do witness intermittent increase in inflation – however,the same evens out over time. Time and again we have seen that many high quality businesses are able to withstand inflation better and in fact have given better “real”returns in the long-term.

—The author is Head – Equities,Mirae Asset Global Investments