Monday, June 19, 2017

Profiting from inflation


During inflation, Goodwill is the gift that keeps giving – Warren Buffett
Stocks are often held out as the best hedge against inflation. And indeed they are — if history is any indication.
Since 1979, equity annual returns have averaged 16 per cent as against inflation of about 6-7 per cent, beating inflation hands down. However, does this mean that corporate performance is better during inflationary periods?
The financials of companies move with inflation trends in four ways. First, it increases the cost of raw materials and labour as well as prices it fetches from selling their products. Second, it changes the cost of funding. Third, it impacts the tax bills. Lastly, it causes shifts in demand levels.
The last eight years have been quite a roller-coaster. Inflation, as measured by WPI (Wholesale Price Index), started at a lower level in 2009-10. For the next four years, it stubbornly remained ensconced at higher levels — averaging about 8 per cent. Subsequently, it cooled to 5 per cent levels in 2016-17.
We did a correlation analysis of inflation with the key financial metrics of BSE S&P 500 companies during this eight-year period. To understand granular realities, we did similar studies at the sectoral level. While inflation was analysed with the aggregate financials of 23 sectors, the study was based on inflation figures as reflected by both WPI and Consumer Price Index (CPI) numbers. While ‘all commodities’ indices were taken for WPI, indices of both ‘combined’ and ‘industrial workers’ were taken for CPI.
Correlation is a statistical measure that indicates the extent to which two or more variables move together. A positive correlation figure indicates that the two variables move in tandem, while a negative figure indicates that they move in opposite directions. The correlation figure varies between -1 and 1. A figure higher than 0.6 or lower than -0.6 usually indicates that the two variables have a strong correlation.
Salsa with sales
For starters, our analysis shows that sales growth of India Inc exhibits a strong positive correlation (0.86) with WPI inflation. Companies from FMCG, entertainment, capital goods, steel, oil and gas, textiles and tyre sectors show a strong positive correlation of their top lines with WPI inflation.
CPI inflation, in turn, has a strong positive correlation with sales growth of auto, construction and telecom services. In all, WPI appears to have a stronger link with the sales growth of India Inc than CPI.
It is not hard to see why inflation moves in sync with sales. Since the turnover of companies is expressed in nominal terms, increase or decrease in inflation tends to impact the realisation of companies as well.
In the two financial years of 2010-11 and 2011-12, when inflation was at its peak of about 9 per cent, sales growth of India Inc was also at its peak. Annual sales growth was at about 20 per cent during these two years. Subsequently, when inflation eased to 6 per cent in 2013-14, sales growth cooled to 14 per cent.
And when a deflationary situation set in, in 2015-16, when WPI contracted 2.5 per cent, sales growth was at its worst — growing by about 3 per cent.
Understanding inflation
In a cost-push scenario, prices rise from an increase in prices of inputs like raw material, labour, etc, which are required to produce goods and services.
And when input costs increase, producers typically try to inflate the prices of goods and services. And the ability of producers to pass on the increased costs separates the men from the boys.
In the past, some cement manufacturers — especially in oligopolistic regional markets — have managed to pass on rise in input costs to their customers.
However, our analysis shows that at the aggregate level, sales growth of cement manufacturers had a lower correlation of 0.54 with inflation. Lower capacity utilisation, coupled with increased competition from regional players, has perhaps impacted pricing discipline in many regional markets — especially central India.
However, it’s not the case for auto manufacturers like Maruti Suzuki that typically manage to fully pass on the higher costs to customers. And it’s no wonder CPI inflation has a strong correlation not only with sales growth (0.74) but also with its net profit growth (0.60) of auto companies.
However, same could not be said of FMCG players, including market leaders like HUL or Marico Industries. The companies have struggled to pass on the increased input costs to their customers. Therefore increasing inflation tends to hurt the bottom line of these companies.
Recently, when copra prices increased, Marico Industries didn’t pass on the higher costs to buyers of Parachute oil for fear of losing market share. A decade back, in 2008 and 2009, when HUL did otherwise and increased the price of its detergents to match rising input costs, it lost 6 per cent market share in detergents to the unorganised players.
Besides cost factors, inflation can also be triggered by demand factors. For instance, when demand outstrips supply. In such cases, the pricing power of the manufacturers plays an important role in their ability to charge a premium for their products.
Bottom-line disconnect
Interestingly, while our study shows a strong correlation of inflation with sales growth of India Inc, it is not the case with its bottom line. Except for banks and oil and gas, none have a positive relationship between net profit growth and inflation.
The weaker link can be explained by the fact that inflation pushes up the cost of inputs and wage, thereby hurting operating profits. Not all companies have the wherewithal to pass on the cost increase to their customers.
Moreover, companies in the B2B segment, such as steel, power distributors and oil & gas, have to absorb the increase in input costs due to regulations restricting their pricing freedom. But companies in the B2C segment, such as auto and FMCG, have greater autonomy to adjust their selling price to protect their margins.
Moreover, as inflation rises, the cost of running existing business goes up, as companies require more money to invest in inventory and fixed assets at inflated costs. The more capital-intensive the business, the more fund-guzzling it will be. Industrial cyclicals like steel, power distributors or construction, typically, face these issues.
Increasing leverage
Also, when inflation is stubbornly higher, as it was during FY’11-13, getting debt becomes a stretch. While large and creditworthy companies face less hassle in getting funding, it’s a challenge for mid-sized companies. And even if such companies manage to get credit, it’s usually at higher interest rates. It creates a vicious circle; more debt weakening the balance sheet and increased financing cost eroding profitability. However, our analysis shows that there is less correlation (-0.25) between growth in interest payments and inflation for India Inc.
However, there are some sectors that are clear winners of an inflationary environment. Our empirical analysis shows that there is a strong correlation (0.76) between WPI inflation and net profit growth of banks. During the high inflation years of FY’11-13, net profit of banks grew at 10 per cent plus rates annually. Subsequently net profit in this sector fell 66 per cent — when inflation turned negative in 2015-16. And it bounced back to a strong 17 per cent growth in 2016-17, when inflation inched up to 5 per cent levels. Bank of Baroda, Canara Bank and Punjab National Bank were among the banks that saw a sharp turnaround in profits after 2015-16.
This is because the prospects of the banking sector and credit growth are linked to the nominal GDP growth of the economy.
While mild inflation and even bouts of higher inflation are good for business, sustained years of higher inflation could have deleterious effects on some businesses — for example, auto sales and entertainment.
For instance, during FY’10-12, when CPI inflation averaged 10 per cent, annual sales were up by a record 30 per cent in each of these years. However, in 2012-13 and 2013-14, when inflation persisted at higher rate of 10.4 per cent and 9.8 per cent, sales growth slowed down to 12-13 per cent levels.
So has been the case with the entertainment companies, when higher inflation years of FY11-13 for CPI are juxtaposed with consistent fall in sales growth rates of 20 per cent, 16 per cent and 12 per cent, respectively. Intuitively, it’s not difficult to understand why it happened. Typically, discretionary spends such as entertainment are among the first to feel the axe when inflation starts pinching consumer pockets.
Bellwether
Usually, investors track real GDP growth to find signs of pick-up in corporate earnings. If the real GDP grows at, say, 8 per cent, corporate earnings are expected to go up by a certain multiple at the aggregate level, say, 1.2-1.3 times that of GDP growth. For instance, cement manufacturers use the ballpark estimate of cement volumes to clock growth rates, that is about 1.2 times that of real GDP growth.
While GDP growth is a robust indicator, the data comes with a lag. Not so, the case with inflation, which is declared every month. By looking at patterns of behaviour of inflation with financials of various sectors, one could get contemporaneous signs of corporate health — especially sales.
While most analysts might be doing such exercises already, what is interesting is our empirical finding that inflation and sales growth do have a strong relationship.
Stock-picking tips
Once the relationship is established, how do we make the most of the inflationary environment? Essentially, it’s all about prudent stock picking and using two dip sticks. One, gauging the ability of the company to pass on the increased costs to its customers and finding capital.
While the former depends on its leadership position, bargaining power and product differentiation, capital requirements vary with the nature of the business.
If the company is able to bypass the deep moat of ‘price pass-through’ and do with little capex, it can tide over inflationary times better. After all, it is saved from the need to invest in inflated building and machinery costs.
In short, look for companies that are less capital guzzling. Or those that have fully done with their capex.They are more likely to do better in inflationary periods. This is because increase in revenue will straight away contribute to their bottom line. You are more likely to find such candidates in consumer-centric businesses than industrial cyclicals. FMCG, entertainment, auto and retail are amongst them. However, play it safe, by not ignoring these companies’ current valuations.
Here are some sector trends
Consumer Durables
If you can recall what you paid for a washing machine or a music system decades back, you will realise that the price has not changed much. Consumer durable players do not have too much pricing power, with intense competition among South Korean, Japanese and Indian manufacturers. It’s no wonder, there is no significant correlation (0.44) between CPI inflation and sales growth of consumer durable companies.
Among the market leaders, Videocon Industries, for instance, has seen its sales vacillate over the years. However, players like Whirlpool India and Bajaj Electricals have held their ground, managing to improve sales year after year.
Oil and Gas
This is one sector whose sales have shown the highest positive correlation (0.95) with WPI inflation. ONGC and Oil India largely make up this universe. Both net profit growth (0.62) and operating profit (0.72) of these companies have shown a strong positive correlation with WPI inflation.
Years of higher WPI inflation — FY‘11-13 — have coincided with higher oil prices, upwards of $80 per barrel. And the latter has usually benefited oil and gas exploration companies.
Construction and Capital Goods
The sales growth of construction companies shows a strong correlation (0.62) with WPI inflation. Interestingly, CPI inflation has an even stronger correlation of 0.81 with it. For capital goods, it’s just the WPI inflation that has a strong correlation with growth in sales. Land and environmental clearances typically delay the projects by a year or two for infrastructure projects, which in turn escalates project costs. Many of the construction companies have been able to pass on these costs to its customers and protect their margins.
Cement
Inflation (WPI) showed a weak correlation with sales growth (0.54). Annual sales growth of cement companies remained above 10 percent levels, when inflation levels were above 6 per cent. Cement companies over the years have put on a lot of capacity in anticipation of demand recovery. However, in the last four financial years, volume growth has still been below the long-term average of 6 per cent. It has impacted the pricing power of companies, especially the large companies. This weak correlation perhaps hints that the cement manufacturers have not been able to pass on higher input costs to consumers.

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