Consumer inflation hit 9.1% in the U.S, the highest level in 4 decades. We are seeing broad increases in the prices of 3 of our daily necessities - Energy, Food, and Housing.
Paying more for items that we use on a daily basis can seem scary, especially when our incomes do not grow in line with inflation.
Some questions might pop up in our minds, examples being:
- How will the inflation affect our cost of living?
- How will our investment portfolios hold up in this inflationary environment?
If this sounds like you, here's how you can get started.
Investing in a stock means investing in a business. Naturally, a good starting point would be by looking at how inflation affects businesses.
How Inflation Affects Businesses?
Imagine we own a chain of supermarkets. We sell $100M worth of items each year. Each year, we pocket $20M of that $100M as profits.
So, we have:
Annual Revenue = $100M
Costs = $80M
Annual Profits = $20M
Without inflation, let's assume a repeat of this performance each year. Each year, we'll get to take out $20M of cash from our supermarkets. That's a steady eddy reliable source of income.
How will this change if inflation is 10% per year instead?
Let's say our customers love our products. So, if inflation runs at 10% per year, let's say we'll be able to raise the prices of our goods at 10% per year, without a decrease in demand. This is where we have pricing power.
So, next year, our price increases will cause our revenues to grow 10%. We'll make $100M * 1.1 = $110M. But of course, our costs (e.g. rent, cost of goods, employee salaries) will also grow 10% . That's what inflation does. So, our costs are now $80M * 1.1 = $88M.
That gives us $22M in profits, a 10% annual increase.
How To Invest for Inflationary Times
When investing for inflationary times, we have to select businesses that exhibit 2 characteristics:
1) Pricing Power
When a company can raise their prices without losing its customers, that’s when you know it has pricing power and a durable competitive advantage.
2) Capital Light
In order to grow, companies need to re-invest into its business.
Capital light businesses do not eat up a big chunk of its owners' profits in re-investments each year. This allows business owners to continually re-invest into the company’s growth.
This is why we commonly see the stocks of big retailers like Target, Walmart, Home Depot being hit HARD when inflation is flying off the charts. Retailers typically need to keep a lot of inventory on their shelves, which requires capital.
Inflation reduces returns for both investors and business owners alike. Inflation fears create a volatile stock market. Only those who survive volatility in the short term can build wealth in the long term.