Understanding the market for profitable assets during inflation

The trending figure from the National Bureau of Statistics (NBS) has shown that the inflation rate as at March is 31.70 percent, from 29.90 percent in January this year. It is no news that rising inflation rate in Nigeria has become a bugbear to investment. The quest to tame inflation has consistently prompted the Monetary Policy Committee (MPC) of the Central Bank of Nigeria (CBN) to keep on increasing the Monetary Policy Rate (MPR). But to what extent will this put inflation under check?

The recent announcement by the apex bank that all banks should recapitalize is a creative way to rein in inflation.

Some of the propellers of Nigeria’s double-digit inflation are insecurity in farming areas with attendant effects on transportation, food supply. There are issues on low purchasing power of consumers along the line. In the securities market, return on equity (ROE) depends on whatever returns the company earns and it is not fixed. This may put equity investors in a helpless position.

However, an investor that has a long-term view can use stocks to hedge against inflation. Stocks tend to grow in value in the long term while holding a diversified portfolio such as 60/40(Stock/Bond) has potential to protect an investor from declining purchasing power. Value stocks, inflation-protected bonds, and real estate are silver bullets that attack inflation.

A value stock refers to companies whose shares trade below intrinsic value, otherwise called undervalued stocks. The security is identified by features such as high dividend yield and low price-to-book ratio (P/B ratio). These companies are noted for superior return. They are large and well-established. This is different from growth stocks which are shares of companies that are expected to outperform the market over time because of their future potentials. But growth stocks may refrain from paying dividends as it will reinvest retained earnings for expansion.

An investor’s choice of growth or value stock depends on his investment objective, time horizon and risk tolerance.  Bonds can be linked to Consumer Price Index (CPI) whereby the principal is reset according to changes in index. This is where investors should contact their investment advisers. Under the current challenges in the global financial market, inflation-linked bonds and Exchange Traded Funds (ETFs), a basket of securities tradable on The Exchange can play vital part in protecting portfolio’s value. Investment in real estate works well with inflation. As inflation rises, property values rise accordingly, and landlords charge higher rental income.

In the United States, there are Treasury Inflation-Protected Securities (TIPS) issued by the government. They are indexed into inflation to protect investors from a decline in the purchasing power of their money. Other assets that hedge investors against the scourge of inflation are: Real Estate Investment Trusts (REITs), commodities such as gold, oil, metal, and grain.

Rising inflation affects returns on equity and bonds negatively. However, the price of value stocks is directly proportional to the rate of inflation. This implies that when inflation rises, prices of value stocks tend to increase. But in the case of growth stocks, it has minimal cash flows  and therefore have negative correlation with inflation rate. Investment in fixed income securities provides an investor with steady income but the rate of inflation can impact on the return on investment. But it can be managed by investing in savings bonds. Stocks of financial companies such as banks and insurance companies, and those of companies in the food and beverages sector, as well as stocks of utility companies can be used as a hedge against inflation. This is why investors need advice from their  stockbrokers on risk aversion  measures in investment.

The stock market investment legend Warren Buffett has always remained vocal on how to invest during inflationary period. Buffett’s company, Berkshire Hathaway, had in the late 1970s and early 1980s devoted significant portions of its annual letter to investing in stocks during inflationary periods in the United States of America. Buffett had reportedly warned before the global financial crisis in 2007 and 2008 that “inflation would cause a shock, and after the crisis, central banking policy would ultimately force a reckoning in stocks.” As an ardent believer in stocks, his timeless statement is: “Be fearful when others are greedy and greedy when others are fearful.” From his practical experience, he believes that inflation swindles equity investors and therefore offered some tips for equity investors : “When you are doing great, it is time to remember inflation: During high inflation, earnings are not the dominant variable for investors: Understand the math of Misery Index; Inflation is a tapeworm that makes bad businesses even worse for shareholders: Focus on companies that generate rather than consume cash”.

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