Ben Carlson has an interesting post about about the impact of inflation on investment returns, and what asset classes tend to outperform during periods of higher inflation. As Ben writes:
“The majority of the usual suspects have been covered here and elsewhere — TIPS, commodities, precious metals equities and real estate to name a few. All of these different investments could protect investors from an inflationary environment, depending on how the cycle plays out.
But there are a couple other options that not too many investors think about when trying to plan for an unexpected rise in inflation or rates — value stocks and international stocks.”
That international stocks would outperform during inflationary periods makes sense; their earnings and dividends come mostly from abroad, and they are generally denominated in other currencies that, when translated into dollars (of lesser value, thanks to inflation), are more valuable on a relative basis.
However, I was surprised to see Ben’s conclusion that value stocks have outperformed during previous inflationary cycles. I would have assumed that inflation would have been equally tough on both value and growth alike. However, when we consider that when we invest in a stock we are paying a net present value for future cash flows, Ben’s finding is not all that surprising.
Consider that growth stocks are typically associated with higher multiples (what I refer to as “perceived value”) based on the expectation that their revenue and profit growth will be faster than the average company’s. If inflation is low, that future growth will be more valuable in today’s dollars, other things being equal. If inflation is higher, that future growth is worth less, so multiples should compress, hence the underperformance.
But with value stocks you typically receive dividends, or what I refer to as “tangible value.” In an inflationary environment, an investor would probably pay more for a higher present ‘tangible value,’ because his equity premium compensation, if you will, is worth more today in the form of a dividend that he can utilize today than it would be in the future were it reinvested instead of paid out.
This is perhaps an oversimplification of the dynamics involved, but I think it serves to show why an investor should have a well-diversified portfolio of both growth and value stocks. I think it also shows that currency hedging of foreign equity positions, – while currently popular, – is generally unwise as you lose some of the diversification benefits of owning foreign stocks, should inflation once again take off.