Inflation

There are concepts outside of what could be considered purely financial or stock market-related that play an important role in investing. Since businesses operate in the real world, lots of factors tend to influence their performance. In this regard, macroeconomic variables are a huge deal, they determine the context in which companies develop, giving shape to the demand and parallel supply products have. On this occasion, we’ll be diving a bit into inflation, but beforehand, a few pertinent definitions.

Aggregated demand is the sum of all individual demands for finished products and services in a certain economy. On the other hand, aggregated supply is the addition of all finished goods and services available in a particular country.

Inflation is defined as an increase in the general prices and services in an economy. This is occasioned by a mismatch between the aggregated demand and the aggregated supply, with AD outpacing AS. Such increase in prices makes each unit of currency buy less products and services, which is the reason why inflation is considered a reduction in purchasing power.

Now, how does it affect businesses?

Uncertainty

Companies create products and services to then sell them to consumers. These products and services have all sort of associated costs; variable, fixed, direct and indirect. When inflation hits, the cost needed to sell such product or service increases. After this happens, management enters in unpredictable territory. It must try to continue purchasing sufficient raw material to produce the expected demanded level.

To aggravate the situation, things gets quite tricky because inflation brings with it consumer uncertainty. Wages generally increase at a slower pace than prices, creating a gap between prices and wages. This gap forces consumers to prioritize certain products over others.

Consequently, management teams are now in an environment where they have to predict accurately how much will raw materials hike prices to buy the right amount, but also keeping in mind that consumers demand has turned completely unpredictable. Between both and many more variables, management has to find an equilibrium of production and they cannot miss, missing would mean under producing or overspending, both of which are inefficient.

Costs

The following is a summarized extract from the book ‘100 Baggers’, which I find as a very clear explanation of how inflation affect businesses.

“The usual belief is that heavy asset businesses are safe haven during inflation periods, like oil producers or gold mining companies.

In a 1983 letter, Buffet goes through a theoretical example to showcase why the previous assumption is incorrect:

Let's imagine 2 businesses:

Business A (mkt cap of 25M): Has 2M in profits while having 4M in tangible assets.

Business B (Mkt cap of 18M): Has 2M in profits while having 18M in tangible assets.

Now let's imagine inflation doubles prices.

Both enterprises need to double their earnings to keep pace with inflation.

Seems easy, right? Just sell the same number of units at double the prices and, margins unchanged, profit should remain the same.

But here's the kicker:

Both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement inflation usually imposes.

But all of these investments produce no improvement in rate of return. it's for survival, not for profit.

Company A needs to invest an additional 4M while company B 18M.

After this round of inflation, if price relations remain the same, Company A will be worth 50M while company B will be worth 36M.

That means that company A would have gained 25M in nominal value on a 4M investment while Company B would have gained 18M in nominal value on an 18M investment.”

Advantages and disadvantages of the different type of businesses

A potential conclusion one could derive from the text above is that asset light businesses tend to get along better with inflation, potentially making out of them a better investment. Even though the first statement may be true, roughly speaking, these kinds of companies have embedded within them a huge disadvantage. An asset light business model is an easier market to enter, since it requires less of an initial investment.

On the other hand, a capital intensive business margins may contract during inflationary periods, but the nominal CapEx investments add to the gross assets the business has. This is one of the factors that build a heavy asset business’ competitive advantage. All nominal investments strengthen the barrier needed to be crossed to enter the company’s market.

Personal Commentary

As mentioned in the introduction, the stock market is filled with variables, some of them being of astronomical importance. The more of them we know about, the better decision will we allegedly be able to make. Hope today’s article helped you understand a bit better on how this phenomena is intricated in the stock market.