How to choose the right stocks for your portfolio in inflationary times

Investing in a changing economic scenario is challenging, especially in times of inflation, when prices of goods and services go up. For the sake of simplicity, the entire gamut of companies can be divided into two buckets: 1. Commodity-oriented companies that supply produce to others, and 2. Consumption-oriented companies that buy such commodities and make and sell products to consumers.

In an inflationary scenario, companies in bucket 1 tend to benefit. They realise more revenue for the same produce. As first-hand producers, their revenue increases at a faster rate than their expenses. This leads to expanded profit margins for commodity producers. The performance of their stocks is directly proportional to the expansion of their profit margins.

On the other hand, consumption-oriented companies are at the receiving end of inflationary wrath. They have to pay more to procure commodities. The cost of processing these raw materials into products does not decrease.

Unfortunately, these companies cannot pass on all of the increased costs to their consumers immediately. Elasticity of demand plays a crucial role. India is still a developing market and a large part of the populace are daily-wage earners. For such a market, it is difficult for companies to pass on costs immediately.

Winning sectors

About 20 percent of India’s GDP comes from agriculture and allied activities. About 25 percent comes from industry (mining, manufacturing, utilities, construction). The remaining 55 percent is from services (travel & tourism, financial services, real estate, public administration and defence).
Mining companies are the biggest beneficiaries of inflation. In the past two years, most companies associated with this sector have performed extraordinarily well.

Manufacturing companies and the entire construction sector are generally at the receiving end of inflationary wrath. This is so because they cannot pass on cost increases immediately.

Companies in the service sector have no linear relationship with inflation. However, banking and financial services companies are in general beneficiaries of inflation. As inflationary winds start blowing, central banks are ready to increase interest rates. At such times, the net interest margin for banks tends to expand and subsequently profitability goes up.

Commodity producers

Commodity producers benefit the most during inflationary times. When inflation is around the corner, investing in commodity companies makes the most sense. However, in the current scenario, most commodity-oriented stocks have already rallied significantly. How does one ascertain whether the momentum in these stocks will continue?

The price-to-earnings (PE) multiples of commodity companies start looking very attractive during inflationary times. This is because the denominator of the ratio (earnings per share) increases significantly, making the resulting PE ratio look attractive.

Here comes the problem. It’s difficult to predict the earnings trajectory of commodity companies. Trying to predict their earnings per share is akin to forecasting inflation, a complex economic variable.

One good indicator in predicting commodity stock prices is their operating margin. Commodities are heavily cyclical and because of this, their margin profile is cyclical as well.

During good times (inflationary), the operating margins of cyclical companies peak. It is counter-intuitive to sell your holdings at peak margins. Greed generally takes over rationality and investors seek ‘more’ from cyclical companies.

There is no clear objective answer to when should one sell cyclicals, but plotting the historical margin trajectory should give some hints. There is a good chance that selling at peak margin point is making the right decision.

Consumption: Long term winner

India is a consumption-oriented economy. A major chunk of India’s GDP comes from consumption of goods and services. In such an economy, inflation often strikes hard because we depend on imported commodities for a substantial portion of industrial demand.

During inflationary times, the purchasing power of consumers reduces and subsequently, demand for consumer discretionary products declines. For this reason, consumption-oriented companies generally struggle to do well in inflationary times. Their expenses rise faster than their revenue growth.
Consumption-oriented companies are relatively easier to analyse because the demand-supply cycles are stable. Inflation’s impact on these companies is adverse, but most often transitionary.

Well-run consumption-oriented companies successfully end up passing on their increased costs to consumers (though this may go for a complete toss during a major economic turmoil as in Nepal, Sri Lanka and Pakistan). However, I am a believer in the India growth story and would like to believe that problems like inflation are temporary roadblocks.

Summing up, if one has the skillset to understand the demand and supply cycles of commodity-oriented companies, one can outperform most investors by investing in and exiting commodity/cyclical companies at the “right time.”

However, for those who may not be adventurous, staying with consumption-oriented companies augurs well. There will surely be some pain for consumption-oriented companies during inflationary times. But for those who believe in India’s growth story, staying put with stable, consumption-oriented companies should work well for the portfolio in the longer run.