Are you also worried about inflation?

With the amount of money governments around the world spent in 2008 and 2009 to pull their economies out of recession the idea of sustained high inflation is increasingly on my mind.

What has really gotten me worried is talk of increased quantitative easing ? a better sounding term for printing money ? mainly in the USA and UK.

What is QE?

Just a quick detour for my jargon free attempt to define quantitative easing:

Quantitative easing is the term central banks use when they increase the supply of money by increasing the amount of money in the banking system.

This policy is usually used when normal methods to control the money supply have failed or interest rates are either at, or close to, zero.

A central bank implements QE by first increasing its own account with money it creates out of nothing. It then buys financial assets, such as government and corporate bonds from banks and other financial institutions in a process referred to as open market operations.

The purchases give banks the excess money they can use to make loans, and thus hopefully stimulate the economy to grow again.

My fear of inflation has been growing even though there are currently hardly any indications that inflation is increasing.

But that is probably because I have been reading how bad things can get if inflation gets out of hand.

For an idea of just how bad hyperinflation is take a look at the article Printing money – A warning from history

Investing with high inflation

My inflation fears got me thinking how I can position my investments to make sure I make real (after inflation) returns on my investments.

In my search for relevant research I found an interesting article called How inflation can destroy shareholder value (free registration required) that appeared in the February 2010 issue of the McKinsey Quarterly the business journal of McKinsey & Company the well known strategy consulting company.

When reading the article what surprised me was that for companies to keep up with inflation have to do a lot more than simply adjust their prices for inflation.

A lot more actually?


What happens when there is inflation?

Just think about it. With inflation the prices of everything goes up. That includes inventory the company has and that will be sold over the next few months as well as all the assets (trucks and machinery) the company writes off over time. This means that when these assets are replaced they will cost more and the depreciation expense will go up.

Not just that but inflation also increases interest rates which means a company’s cost of borrowing as well as returns expected from shareholders. This means its total cost of capital increases.

All these added expenses mean the company must do far more than simply adjust its prices for inflation.

Getting back to the article.

Increasing earnings at the rate of inflation is not enough

The authors mentioned that in the high inflation period from mid 1970s to the 1980s US companies managed to increase their earnings at about the same rate as the 10% inflation rate. They however calculated that companies had to increase their earnings at close to 20% to preserve shareholder value.

The authors conclude that this was one of the reasons for the poor stock market returns in over the period.

The biggest risk companies? face in an inflation environment is that they are not able to fully pass on cost increases to customers without losing sales volume.

The authors say that to ensure that the cost of inflation is fully passed on to its customers the company must ensure that they raise the cash flow the company generates by the rate of inflation and not earnings.

This is much more difficult to do because increased working capital investment ? due to higher prices paid for inventory and higher value of accounts receivable ? gets deducted from the cash flow the company generates.

Not surprisingly the authors found that historically companies have been unable to adequately increase prices to offset the costs of inflation.

Time lag is a problem

The other reason companies are unable to keep up with inflation is that they pass on price increases with a time lag. Timely price increases are especially important in high inflation environments.

They give the example of a company passing on a 15% price increase six months later. This results in sales always being 7.5% too low causing margins to decline substantially.

High or rising inflation are usually bad for share prices because first of all managers do not manage to keep up with price increases but also because investors increase their required returns in real (after inflation) terms.

Companies are then only able to meet these higher return expectations if their share price declines.

Inflation is thus a tricky business.

As you can see you must be very careful of what companies you invest in during times of inflation.

The company must be able to pass on price increases fully without losing sales volume, adjust prices often as soon as prices increase.

And all this must be done to ensure that the cashflow the business generates grows with inflation.

Your inflation thinking analyst