Inflation Chart

Value Investing as a Hedge Against Inflation

Financial Commentary
May 16, 2022
Michael ListBy Michael List, CFP®
Investment Management Officer

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output,” Milton Friedman once said.

Most people have a tolerate/hate relationship with inflation. We tolerate inflation when it’s low, but hate inflation when it is high or changes rapidly.

High or rapidly changing inflation make the already difficult task of forecasting even more daunting — whether you're a couple planning for retirement or a business owner considering expansion. How people, businesses and financial assets respond to inflation depends on a variety of factors: the rate and speed of change, how long is it expected to persist, and the underlying causes, just to name a few.

One of the phrases I learned studying as an amateur economist was “all else equal.”  It is a way to look at a given situation, change one factor but leave everything else the same, to evaluate the potential impact. In today's article, we will look at the impact inflation has on two different types of stocks: growth and value.

Inflation’s Impact on Growth vs. Value Stocks

The chart below from Yardeni Research, Inc. shows the breakdown between growth and value over time, in terms of Price-to-Earnings (P/E) ratio.

Chart

Through 2021, when inflation was ‘transitory’ and expected to moderate, growth stocks were trading around a P/E of 30 and value stocks were trading at around 17.  Based on those ratios, investors were paying $30 for every $1 of growth a company earns. Said another way, 1/30 of a growth stock’s price is today’s earnings and 29/30 are future earnings. In contrast, 1/17 of a value stock’s price is today’s earnings and 16/17 are future earnings.  At these price levels, much more of the growth company’s price is based in the future, compared to value stocks.

Here is a hypothetical example to help illustrate how inflation can affect different types of companies.  Let’s say we have two companies Growth, Inc. and Value, Inc.  Based on our research, we expect Growth, Inc. to grow earnings at 11% and Value, Inc. will grow earnings at only 3%.  Now, it is reasonable to pay more for Growth, Inc. stock, because future earnings will be much higher. The question is how much more? 

If both companies earn $1 per share today, assuming the above growth rates, in 15 years earnings per share would rise to $4.30 for Growth, Inc. and $1.50 for Value, Inc.  Those earnings will be in the future, therefore, we need to adjust for inflation to see what those earnings are worth today.  With a 1% discount rate, the stream of earnings in current dollars is $31.20 for Growth, Inc. and $17.10 for Value, Inc.  But, what if inflation is higher?  What if the discount rate changes to 3%?  Now the stream of earnings in current dollars is $25.90 for Growth, Inc. and $14.60 for Value, Inc.

All else equal, higher inflation has a more significant impact on Growth, Inc. This is why in an inflationary environment, value stocks can offer some refuge to better protect your portfolio from that impact.

Of course, we live in a complex world. A change in one factor will have ripple effects throughout the system. We have seen a compression of valuations in 2022, and some of this can be explained by persistent inflation (along with other contributing factors).

What does this mean for you?

Inflation has been one of our concerns since the extraordinary stimulus response in early 2020. During inflationary periods, investors favor cash flow today rather than promises far in the future, all else equal. Portfolios in our care have been structured with this in mind. For equities, we have a tilt toward value stocks that typically have a lower price and higher dividend. For fixed income, we’ve shortened up duration and maturities so we receive cash sooner to reinvest at higher rates. If you would like to discuss how your portfolio is structured reach out to your Advisor.

About the Author

Michael List, CFP®

Michael List is an Investment Management Officer within Security National's Wealth Management Division. Michael earned his Bachelor of Science in Business Administration with a concentration in Finance and Economics from Creighton University and holds the esteemed Certified Financial Planner, CFP® certification. List helps execute investment strategy, transactional execution and overall portfolio management. Having dedicated 14 years to the field of Wealth Management, Michael List brings a wealth of experience to his role, contributing to the success and growth of Security National Bank since 2008.

Related Articles

Spring Cleaning:  Time to Cultivate Your Financial Plan April 15, 2024

As the old adage goes, April showers bring May flowers. Depending on where you are from or walk of life, this proverb can take on many meanings. The way I interpret the classic saying is that April represents a time for preparation. A time to do some spring cleaning and tackle projects neglected during the winter months. For farmers, it means a return to long days in the fields. For accountants, it signifies the conclusion of an arduous three months of tax preparations. At Security National Wealth Management we feel now is a great opportunity to assess your financial plan and ensure you are on the right path to achieving retirement goals.
Look What's on the Verge of a Major 40,000 Milestone April 1, 2024

In early December 2020, my colleague, Michael List, published an article marking the Dow Jones Industrial Average hitting the 30,000 milestone. In that article, Michael describes four different methods that each provide us with an educated guess as to when the Dow would cross the 40,000 milestone, with guesses ranging from two to six years. Michael said that the 40,000 milestone probably would be here faster than we expect but that it ultimately would leave us with more questions, e.g., when would the Dow reach 50,000? And now, about 40 months later, or 3.33 years, the Dow is approaching 40,000, causing us to guess when it ‘turns’ 50,000. To continue our analysis, let’s use the same methods utilized by Michael to predict the arrival of the Dow at 50,000.
Unveiling the Fed: Journey from 'The Great Oz' to Transparency March 25, 2024

One of the evolutions in my investment career was the increasing transparency of the Federal Reserve over time. Decades ago, the Fed was seen as ‘The Great Oz’, its deliberations hidden behind the curtains and then revealed to the public through its actions. Deciphering the Fed’s inner workings was a cottage industry on Wall Street. Clarity in public pronouncements was not a priority for the Fed. The environment is much different today.