Investing in 2022 has a “through the looking glass” feel. What is usually up is now down. Energy is the only sector in the S&P 500 with a positive return year to date and the Nasdaq is down more than the S&P 500. Investors who bought bonds to dampen volatility may do a double-take when they look at their portfolio: over the trailing twelve months, the Barclays Aggregate Bond Index is down more than the S&P 500. The force driving these market distortions is inflation, which is reshaping interest rates, valuations and investor sentiment. Given that disinflation, the opposite of inflation has been the economic backdrop in the U.S. for 40 years, there are times in 2022 when it feels like everything we have learned about investing should be thrown out. There are times when it feels like a new rule book is needed for this new paradigm.
Many investors, in search of such a rule book, have turned to the 1970s, the last period of significant inflation in the U.S. They have naturally drawn parallels between the market peak at the end of 2021 and the market peak of the “Nifty Fifty” stocks in the early 1970s. The Nifty Fifty were the blue-chip growth stocks of their day. Much like many of the top performing stocks of the last 10 years, the Nifty Fifty were large, profitable companies that were bid up to lofty valuations. Their significant underperformance in the 1970s is one of the lessons investors cite from the era. One of the morals of the Nifty Fifty’s story is that blue-chip growth isn’t the right type of exposure when inflation is high. Instead, investors who look for lessons from the 1970s have recommended buying gold, energy companies and commodities—all investments that performed well in the 1970s compared to broader stock and bond indices.
But is that the right advice? And does it apply to the market investors face today?
To answer this question, let’s take a step back and turn to first principles thinking. Rather than examining the differences and similarities between the two time periods, let’s start with a blank slate and answer the question: “What kind of business do I want to own when inflation is high?”
Inflation is insidious because it simultaneously increases costs, increases discount rates and, because of tighter financial conditions, decreases demand and growth. Therefore, the ideal business is one that can survive and thrive under these three conditions. In short, we want a business with high margins, high returns on capital and high growth. Let’s break down each of these three characteristics.
High margins are attractive in any economic environment, but they take on greater importance when inflation takes root. Simply put, high margins give a business more cushion to absorb increasing costs
and stay profitable. High margin businesses face less pressure to push through price increases than low margin businesses. For example, if cost inflation is 10%, a business with high margins—say 50%—only has to increase its prices 5% to pass through increased costs. Meanwhile, a low margin business where costs are 90% and profit margins only 10% will have to increase prices 9% to pass through the same 10% increase in costs. The knock-on effects of this difference can be vicious: after passing through these cost increases, the high margin business’s product is now priced more cheaply relative to its lower margin competitor, meaning it can move more volume and continue to bring per-unit costs down. Meanwhile, the low margin business loses sales due to the larger price increase, which further decreases margins as lower revenue is spread across the fixed portion of its cost base.
A business’s capital intensity is less readily apparent than its margins, but it is just as important as when considering inflation’s impact. A capital light business earns relatively high profit on each dollar it invests. As we well know from following markets in 2022, inflation causes discount rates to rise, which means that the hurdle rate of return for profitable new investment increases as well. A capital-intensive business with low returns on its investments will no longer be able to grow profitably. In practical terms, when inflation rises everything a business buys to maintain and grow its revenues costs more. Factories, offices, logistics, employees—everything a business spends money on becomes more expensive. Therefore, businesses that are asset intensive, meaning they derive relatively little revenue from each dollar they invest in assets, get squeezed.
Finally, the most basic goal of an investment is to increase profits in real (after inflation) terms. High inflation makes this even more important. When inflation is low, nominal and real growth are similar, and finding companies that are growing in real terms is easy. But when inflation is high, most businesses increase their nominal revenues, and it becomes important to look under the hood and see what is really going on. Unless a business can raise prices in excess of inflation, which is more difficult when inflation is high, then real profit growth needs to come from increasing the volume of products or services sold. In the most ideal scenario, this is done while increasing returns on capital in line with inflation, so that real returns on capital remain constant or even increase. Finding companies like this is easier said than done, but companies that are growing because they provide unique value to their customers is a great place to start. Unique value allows for cost increases to be passed on, and, as the company grows on a units-sold basis, its profitability increases along with its scale, which can further increase its return on investment and therefore its self-financed growth rate. This positive feedback loop is only possible with real output growth. When inflation and higher rates decrease aggregate demand, real output growth is harder to find. It is of the utmost importance, however, because these companies are the only ones that will increase an investor’s purchasing power during times of inflation.
One of the surprising conclusions of this analysis is that the three characteristics we most want in a business when inflation is elevated—high margins, low asset intensity and high growth—are also three of the most desired characteristics in a business when inflation is low. This begs an important question. If the types of businesses we want to own haven’t changed, then why are the stocks of the “quality growth” companies that check all three of these boxes—think Microsoft, Pfizer, Blackrock, Intuit, American Tower, Google—underperforming the market year to date? They should always trade at a premium to the market from a valuation standpoint, but why has that premium decreased?
Broadly speaking, there are only two answers: 1) quality growth companies were overvalued at the end of 2021 and are therefore fairly valued (or closer to fairly valued) now, or 2) quality growth companies were fairly valued at the end of 2021 and are selling at an attractive discount to fair value now.
A potential clue to the answer can be found by re-examining the fate of the notorious Nifty Fifty. The commonly held belief is that these stocks were overvalued at their peak in 1972. However, if a longer view is adopted, the results are surprising. In 1998, Jeremy Siegel, a professor of finance at Wharton, published a study in the American Association of Individual Investors Journal that followed an equal-weighted portfolio of the Nifty Fifty stocks from their 1972 peak until August of 1998. The results? From that lofty, “overvalued” perch, their performance matched the S&P 500 over the next 26 years. Put differently, at their peak, when their average P/E ratio was more than double the S&P 500 (41.9 vs 18.9), they were actually fairly valued because the expected growth in earnings actually materialized over the longer term and offset the decline in their earnings multiple.
If the Nifty Fifty were fairly valued at their peak and delivered the same returns as the S&P 500 over the next 26 years, what would have the returns been if an investor bought after the 1973-74 sell off? In hindsight, that was the real investment opportunity: quality growth available not at a fair price but at a discount. From November of 1975 until August of 1998, investors who invested in an equal weighted portfolio of the Nifty Fifty stocks would have earned 16.6% per year, and their portfolio would be worth 25% more than if they had invested in the S&P 500. Investors who bought then would have benefited not just from outsized returns but from achieving those returns with less risk by owning profitable, high-quality companies.
Quality growth stocks aren’t an attractive investment opportunity today just because history often rhymes. They are an attractive investment because inflation puts the same pressures on companies today as it did then. The ability to weather the inflationary storm requires a business to be high quality and to be able to increase real revenues fast enough to outrun a contraction in real GDP. Rather than chase commodity companies that masquerade as quality growth until supply catches up and prices fall, these businesses compound economic value when inflation is high and subsequently reward investors with outsized returns as inflation subsides and discount rates fall. Rather than try and time exactly when market sentiment turns, the better approach is to accumulate positions of these unloved but high-quality companies at a relative discount and ride out the storm in businesses that can thrive in all economic environment
Members of the editorial and news staff of the Las Vegas Review-Journal were not involved in the creation of this content.