Should You Buy Stocks To Hedge Against Inflation?

There is a common notion that one of the best ways to protect your money from losing its value from the effects of rising inflation is to invest it in the stock market.

Stocks are seen as an excellent hedge against inflation because they generate returns faster than the growth of general level of prices in the long run. Market history will show that over the past 10 years, the PSE index has gained an average of 11 percent per year compared to a 5-percent increase in inflation.

But how come whenever the national headline inflation rises, the market always falls?

One explanation for this relationship is the impact of inflation on interest rates.

Rising inflation raises fears of higher interest rates, which translates to a higher discount rate.

The discount rate is the minimum rate of return required by investors to invest in stocks.

The amount of the increase in discount rate is also affected by the level of riskiness in the market.

When market sentiment is bad, risk premium tends to increase, which adds to discount rate. Share prices fall because a higher discount rate demands cheaper stock valuations.

Meanwhile, companies that are affected by rising costs due to inflation, ideally, should be able to adjust by raising their prices to protect their profits. Higher prices will boost revenues and profits to grow, which leads to higher share prices in the future.

Unfortunately, not all listed companies are quick to adjust with inflation.

Some companies do not have the pricing power to always pass along increased costs to consumers, which results in lower profit margins and earnings growth.

The key to finding a stock that will safeguard against inflation will depend on the ability of the company to grow its earnings in the future.

How much should a company grow its earnings to fight inflation? Remember that the discount rate is also a function of the earnings yield plus the growth rate of a stock.

The earnings yield is computed by taking the inverse of a stock’s price-to-earnings (P/E) ratio while the growth rate is derived from the company’s sustainable growth.

Imagine when the discount rate increases due to inflation, either the earnings portion of the inverse P/E ratio or the growth rate on the other side of the equation must also increase with the same magnitude.

If nothing happens to these two variables, share price will fall until the increase in earnings yield compensates the increase in discount rate.

Theoretically, a stock can be a good hedge against inflation if its growth rate aligns with inflation so it can keep its share price from falling.

But if a stock were to appreciate in value over the long term, its earnings must grow higher than inflation.

The sustainable earnings growth of a stock is derived by multiplying the return on equity with the retention ratio.

The retention ratio is the portion of the earnings that is retained by the company to grow the business after paying dividends.

Imagine if a company is able to boost revenues by raising prices more than the effect of higher input costs, additional earnings will increase its return on equity and dividends.

Based on the average sustainable growth rates of the 30 companies belonging to the PSE index for the past three years, the median growth rate is about 7.9 percent, which is higher than the inflation target of 4.5 percent.

Some of the notable stocks that have sustainable growth rates higher than the market median of 7.9 percent include Aboitiz Equity, 10.2 percent; Ayala Land, 9.7 percent; BDO, 8.5 percent; Jollibee, 11.3 percent; Puregold, 9.9 percent; Robinsons Retail, 8.2 percent; and SM Prime, 8.6 percent.

While stocks may not respond positively during times of rising inflation, it is evident that investing in stocks, particularly those with growth rates higher than inflation, will allow you to stay ahead of the curve in the long term.

****