Why Value Investors Shouldn’t Worry About Inflation
Yes, inflation may occur but the same strategy will succeed whether it does or not
Inflation has been the talk of the financial news in recent weeks. There are concerns across the board that drastic increases in federal spending coupled with household savings and loose monetary policy will create demand-side inflation. In essence, investors and economists are worried there will be too much money chasing too few goods and prices will begin to rise. Put simply: the entire investor community is scared that there is too much money and not enough stuff. On the money side, this recession has been a bit unique in that, due largely to unprecedented federal intervention, many are leaving the recession better off than they started with drastically more savings that they are prepared to spend as the economy reopens. On the supply side, the worry is that because of the unique nature of this recession — a pandemic rather than another cause — we will see a much faster rise in demand than we’ve seen in previous recessions and suppliers will be unable to ramp up quickly enough to meet this demand.
There is little debate about whether these factors will cause inflation. Even the US federal reserve acknowledges that price increases are likely. We’re already seeing annualized 4.2% CPI inflation the most recent April 2021 print. The main divergence in thought is that some, including the federal reserve, believe this inflation will prove to be transient whereas other believe it will spark an inflationary spiral that will persist for years. I do not have some magical ball that will tell me who is right in this scenario. I have no idea which scenario will play out and, quite honestly, I don’t really care. I do not care because regardless of the true possibilities of both of these outcomes, the substantial risk that the other may occur means only one investment strategy is worth pursuing: value-based investing.
The basics of value investing
Value investing is a principle initially preached by Benjamin Graham in the early 1900’s then popularized by Warren Buffet. In essence, value investing relies upon investing in undervalued investments for long periods of time. The concept revolves around the idea that: As these companies continue to deliver positive results, their value will tend to rise both to account for business growth and to seal the gap of their undervaluation.
There is not a single metric by which companies are valued. Rather, companies are valued by a plethora of factors ranging from book value & earnings to industry outlook and talent. Its the quantity and uncertain confluence of these factors that makes value investing more of an art than a science. Hence the reason why we aren’t all sitting on a few tens of billions of dollars in Omaha. It is also for this reason that I will strictly be talking about sectors and assuming ETF-based value investing stratagem.
Why value investing
Value investing has been pushed a bit to the back burner over the past decade. Fast growing companies — especially those in technology — have attracted much of the investment inflows in recent years. While some tech behemoths do have the fundamentals to justify their valuations, many do not. On many valuation metrics, the technology sector’s valuations are starting to approach those seen before the dot-com crash. Regardless of whether another technology doomsday happens, long term reversion to the mean will likely mean underperformance of the broader technology sector in the medium term. While its anyone’s guess when such a correction would occur, there is inherent risk in the sector that should lead investors to diversify out of this historically outperforming sector.
These risks are then compounded by inflation risk that devalues potential future cash flow at a higher rate. That may be gibberish to those outside of the investing space so let me break it down to more elementary components. The justification of higher valuations of the technology sector is faster growth; because their earnings and revenues are growing at comparably faster rates, they should fetch higher value valuations in the present. In other words, the technology sector is valued based largely upon its’ future performance more so than most other sectors due to its growth rate. In periods of high inflation or risk thereof, future cash flows become risky. 10% growth becomes far less impressive when there is 5% inflation. In essence, inflation eats away at the growth numbers and, given the same valuation metrics, lowers the valuation of companies valued on future performance. Those companies valued on present cash flows and book values are left largely untouched because much less of their valuation is derived from this discounted future performance. They can even be helped if they happen to be within sectors seeing higher demand and, consequently, prices rising faster than those in the broader economy.
This is where value investing comes in as an appealing investment opportunity, regardless of inflation’s eventual showing. If inflation ends up being only transient, low valuations in value sectors and sky-high valuations in the technology sectors points to a turning of tides. If inflation is persistent, the tradeoffs will only become more skewed as investors make a mad dash to companies valued more on present cash flows. In fact, this is something we’re already seeing now purely because of risk of inflation becoming persistent.
Value Investing’s Unique International Opportunity
Following value investing’s traditional principals, you’ll find somewhat limited opportunities within the United States. The rally in markets over the past year has meant even “value sectors” in the USA are not quite looking cheap. Many of these value sectors, such as financial services and energy, are trading at & above average historic valuations in terms of earnings, growth and book value. This doesn’t necessarily mean they are a bad deal or won’t deliver returns, but it does mean there is more uncertainty in these investments. While this is the case in the United States, this is not the case in every market around the world.
Other markets — such as those in Europe & Asia — have drastically lower overall market valuations than those currently seen in the US. I’m going to use one somewhat-incomplete but simple comparison metric: the CAPE ratio of countries’ leading market index to demonstrate this point. The US, as of the beginning of this year had a CAPE of 33.4 whereas Canada was at 22.8, China at 18.1, and the UK at 13.7. Building on this fact, the current CAPE ratio of the US market has only been higher once before — just before the dot com crash of the early 2000’s. Again, while this doesn’t mean the US is heading towards impending doom, it does mean greater uncertainty and likely lower upside potential than other markets around the world
Now this is a particularly interesting phenomena because it not only presents a good value opportunity, but also allows you to hedge the US dollar. In the case of US dollar inflation and weakening, companies reporting earnings in non USD currencies would have an additional tailwind. This is due to an idea called currency risk whereby companies valued in USD but with revenues largely earned in other currencies are impacted not only by their companies performance, but also foreign exchange rates. As a US investor, every ex-US company you decide to invest in introduces your portfolio to these currency risks. While typically currency is viewed as a negative and something investors like to hedge against, it presents a particularly interesting opportunity in the current market climate. It allows to hedge against US dollar inflation while taking advantage of promising investment opportunities. Now this also introduces another layer of risk to your portfolio so it should be done, as with anything in investing, with proper diversification. Done intelligently though, it can act as an alternate method of hedging against inflation risk without buying gold or Bitcoin.
Value Investing’s Appeal In An Uncertain World
While the future cannot be known, current valuations and prescient risks mean that value investing — especially in ex-US markets — is an incredibly appealing strategy. Not only have Warren Buffet & others proven its long term efficacy but short term undervaluation and inflation risk means that higher than average returns are all the more likely. These factors coming together is why I believe that, regardless of inflation’s eventual path, value investing is poised to succeed in the years to come.
