Chas Craig, BridgeTower Media Newswires
“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”
– Warren Buffett,
1982 letter to Berkshire
Hathaway shareholders
In early April of this year I was asked to participate in a JR Now webinar hosted by Journal Record Editor Joe Dowd regarding inflation. About two-thirds of the way through, Mr. Dowd asked a question regarding what the implications are for the investment landscape of the current inflationary environment. I’ve been intending to expand upon my verbal response in a column ever since. One could have gone several different directions with the question (e.g., discuss gold or other alternatives), but I chose to tackle it from the standpoint of a common stock investor, where much of my analysis time is spent.
First, one must acknowledge the difficulty of the question because it gets at the heart of the investment problem, which is a tug of war between fundamentals on the one hand and valuation on the other. From a fundamental standpoint, the businesses best positioned to weather a prolonged inflationary environment are those with high profit margins (i.e., low cost structures), low capital intensity (i.e., don’t need to reinvest heavily to maintain or expand production capacity), pricing power (i.e., can raise prices to offset higher input costs without a material commensurate reduction in unit demand) and are growing sales quickly.
Unfortunately, the valuation side of the investment equation assures that there are no free lunches, for the sorts of companies that possess the fundamental attributes listed in the preceding paragraph typically command very fancy valuations in the stock market. So, to the point of the opening quote, while the businesses with excellent fundamentals and the brightest growth prospects are fundamentally best positioned to weather an inflationary environment, valuation considerations make it such that the stocks of such businesses are not obviously the best investment choices given such an environment.
Consistent with the paradox that owning the stocks of the businesses best positioned to “win” in an inflationary period may prove a losing investment proposition, consider that the S&P 500 Growth and Value Indices have returned -17.6% and -6.5% respectively year-to-date. In aggregate, the growth style, with its largest weighting in the technology sector, is populated more by the sorts of companies with the attributes listed above than is the value style, with its largest weighting to the financial sector, which sports a lower valuation as a result.
So, sticking with the tug of war visual, although not as ferociously as it may seem at first glance given the year-to-date return figures shown owing to the material outperformance of the energy sector (which features more prominently in the value index), valuation has pulled harder than fundamentals for most of the year. Higher inflation expectations have driven up long-term interest rates (i.e., The yield on 10-year Treasury Notes started the year at 1.5%, and it is now 2.8%.), which has had a disproportionately negative impact on the valuations of companies where a relatively larger portion of intrinsic value is associated with profits in the more distant future (i.e., higher valuation multiple growth stocks).
Where is the best place to invest prospectively? If only we knew. Depending on the valuation measuring stick used and how “growth” and “value” are defined, value-style companies remain cheap to generationally cheap relative to growth style companies. So, it might be that valuation tugs harder than fundamentals for a while longer. However, if this does occur, at some point, valuations will normalize, or overshoot and growth companies will again represent the best investment values.
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
