Inflation might be transitory, it might also be here to stay so make sure your portfolio is ready for whatever happens…
In this article we look at a few key considerations, why it is important to have a strong grip of the concepts of value and growth, and how we can use that to better protect our portfolios….
Value vs. Growth
To fully understand how inflation will affect your holdings, we first want to get a good grip on the concepts of value and growth…
- A growth stock is merely one which grows its capacity to generate cash flow as fast or faster than the median stock.
- A value stock is simply a stock which is priced at less than it is worth.
…When we talk about value, we think of “value now”. When we talk about growth, we think of “value later”. Stocks can be value stocks, growth stocks, both, or neither…
What does any of this have to do with inflation?
Inflation is the erosion of the value of a dollar. Today you can buy something with a dollar, but after inflation, you need more than a dollar to buy that same thing so money in the future is worth considerably less than money today and this is why a growth-oriented fund like Invesco’s QQQ ETF (QQQ) has underperformed the S&P 500 (SPY) year to date.
As talk of inflation took over the market, the perception of future profits is relatively dimmer than profits today. If inflation is 5% rather than 2%, then for profits to be equal in purchasing power, they need to grow at 5% rather than 2% so, with inflation, “value later” goes down, all else held equal, while “value today” goes up.
The above explains the rotation we’ve seen in valuations from growth to value during the past 6 months – the opportunity cost of money goes up, so the value of a future dollar goes down.
When you believe inflation might be transitory, this happens a little bit in a “wait and see” kind of approach.
- If it is transitory, we’ll most likely see deflationary pressures taking over again, and valuations go higher in growth stocks.
- If it isn’t transitory, however, the rotation from growth to value will continue.
What happens without growth?
Without growth, in an inflationary environment, you’re toast. If your costs rise quicker than you can increase your revenues, profit margins will start thinning, or disappear altogether. With inflation, higher interest rates follow, which means higher costs to service debt. Everything costs more. In fact, growth is the only thing which can keep the lights on. It can either come from increased volumes or increased prices and this is where pricing power, and therefore quality comes into play. If you can pass on the costs of inflations to your clients, then you can weather inflation…
…By focusing on quality, value, AND growth, you can buy stocks that will do relatively very well if inflation proves to be more than transitory. If it never manifests, you’ll be just fine too and those are the best situations: heads you win, tails you win more.
Editor’s Note: The original article by Robert and Sam Kovacs, has been edited ([ ]) and abridged (…) above for the sake of clarity and brevity to ensure a fast and easy read. The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.
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