Demystifying Value Investing During Inflation

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Inflation refers to the rise in the price of goods and services, resulting in lower purchasing power of each unit of currency. The Federal Reserve, for long, had kept near-zero interest rates. The low interest rate coupled with low inflation had provided a conducive environment for the growth stocks to thrive in 2021. Come 2022, Russia-Ukraine war, commodity crisis led rising prices, and an inflationary environment compelled the US central bank to raise key interest rates.

 

Why interest rate hikes are good news for value investing?

Globally, inflation is wreaking havoc across economies. The US consumer price index (CPI) rose 9.1% on a year over year basis in June, marking the largest gain since the end of 1981. The closely followed inflation gauge increased 1.3% over May, the most since 2005, owing to higher gasoline, shelter, and food costs. Given the backdrop, Fed appears confident on interest rate hikes as a counter measure to handle decade-high inflation. This move is expected to strengthen dollar. However, major global central banks have followed suit in hiking key interest rates to support their own currencies.

For instance, UK consumer price index rose 9.4% annually in June, up from 9.1% in May, marking a new 40-year high as food and energy prices continued to soar. Following this, the European Central Bank raised its key interest rates by 50 basis points (for the first time in 11 years) to 0%, ending a nine-year experiment with negative official interest rates, to bring down inflation from record highs. Although, the central banks are leaving no stone unturned to combat inflation, the problem is likely to linger in the days ahead. Growth investing tends to exhibit superior performance in a low interest rate, low inflation situation. However, as the era of easy money appears to be over amid surging interest rates, value investing comes to the forefront.

 

What differentiates value investors from growth investors?

The famous quote from Warren Buffett, the Oracle of Omaha, “Price is what you pay, value is what you get,” comes to the rescue, given the macroeconomic dynamics. Any individual trading in the stock market is generally aware of two broader categories of companies – value and growth. Value investors use fundamental analysis to look for companies that appear to be selling below their perceived intrinsic value. Meanwhile, growth investors look for younger companies with strong prospects, and enough room to generate profits in the future.
 

Why value investing gains importance during inflation?

Value investing is preferred to growth investing amid inflation due to lower share prices, lower market risk, and dividend income. In stock trading, there is a constant tussle between which stocks to opt for at what time, as not even the best investors can predict how the market will behave tomorrow. Here we discuss how value companies cushion each disrupting factor amid inflation and interest rate hikes as compared to the growth companies:
 

1. High input prices weigh on margins

Inflation hits hard in terms of surging prices of inputs like raw materials, labor, and overhead, used in the production process. Due to high input prices, companies experience lower profit margins. Value stocks often have a relatively low price/earnings (P/E) ratio and strong current cash flows. Meanwhile, growth stocks tend to represent fast-growing companies that may not have started generating profits. Thereby, in times of rising interest rates, growth stocks are seen to be negatively impacted far more than value stocks, while valuing stocks based on the discounted cash flow method. 

Here’s something to gain more clarity on Value ETF vs Growth ETF

 

3. Lower consumer spending

Inflation weighs on consumers’ purchasing power, which reduces the demand for the goods and services sold by companies. This results in lower corporate revenue and net income, which does not bode well for investor confidence. Value companies, however, offer dividends, and are generally known to be associated with utilities. Hence, the fall in demand for value stocks isn’t as significant as it is for growth stocks.

 

3. Rising rates make debt expensive

High inflation has compelled central banks, globally, to raise interest rates, increasing the cost of borrowing. This factor impacts growth companies more as value companies often have a sound cash flow generating ability, making debt access easier backed by strong free cash flow.

 

Wrapping Up

Although there is no perfect inflation hedge, historical data suggests that value investing strategies tend to perform very well, on average, amid high inflation periods. Meanwhile, growth stocks perform better when inflation is low. It is prudent strategy to weigh all the options that are projected to offer a hedge against inflation. A financial consultancy can help you develop a portfolio that both reflects your goals, timeline, and risk profile as well as factors in the inflation parameter.

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