Inflation, deflation and investing

I must confess that I have never seen such dissension and disagreement among economists about whether we are going into a period of inflation or one of deflation. On the one side, there are those who are alarmed at the easy money, low interest rate policies that have been adopted by most central banks in developed markets. The surge in the money supply, they argue, will inevitably cheapen the currency and lead to inflation. On the other side, there are many who point to the Japanese experience where a stagnating economy and weak demand lead to price deflation. I have given up on trying to make sense of what macro economists say but you probably have a point of view on inflation and are wondering how inflation or deflation will affect your portfolio.

To understand how inflation affects the value of a company, let's get down to basics. The value of a company can be written as a function of its expected cash flows over time and the discount rate appropriate for these cash flows. In its simplest form, the value of a stable growth firm can be written as:
Value = (Revenues - Operating Expenses - Depreciation) (1- tax rate) / (Cost of capital - Stable growth rate)
Assume now that inflation jumps from 1% to 5%. For value to be unaffected, everything has to increase proportionately. Thus, revenues, operating expenses and depreciation all have to increase at the inflation rate, the tax rate has to remain unchanged and the discount rate will have to increase by that same percentage. So, what might cause this to break down?
a. Lack of pricing power: Even though the overall inflation rate may be 5%, not all firms may be able to raise prices by that magnitude. Put simply, firms with loyal customers, a strong brand name and significant competitive advantages will be able pass inflation through better than firms without those benefits.
b. Input costs: By the same token, not all input costs will increase at the same rate as inflation. If oil prices increase at a rate higher than inflation, an airline that lacks pricing power may find itself squeezed by higher costs on one side and stagnant revenues on the other.
c. Tax rate: The tax code is written to tax nominal income, with little attention paid to how much of the increase in income comes from real growth and how much from inflation. Thus, the effective tax rate you pay may increase as inflation increases.
d. Cost of capital: The effect on higher inflation will be felt most directly in the risk free rate, which will rise as inflation rises. However, equity risk premiums (which determine cost of equity) and default spreads (for cost of debt) may also change.

Historically, higher inflation has not been a neutral factor for stocks. Stocks have done worse during periods of high and increasing inflation and much better in periods of lower inflation. This graph, which I borrowed from a Wall Street Journal article, illustrates the stark divide:

That may seem puzzling because we are often told that it is bonds that are hurt by inflation and that stocks are good inflation hedges. Here is why I think the logic breaks down. When inflation increases, equity investors are hurt for two reasons. The first is that the discount rate (cost of equity and capital) increases more than proportionately, because risk premiums increase with inflation. For instance, the equity risk premium in the United States increased from 3.5% in 1970 to 6.5% in 1978 and default spreads also widened. The second is that the tax code is not inflation neutral. For companies that have substantial fixed assets, depreciation is based upon historical cost and not indexed to inflation. Consequently, the tax benefits from depreciation become less valuable as inflation increases; think of it as an implicit increase in your effective tax rate.

If I believed that high inflation was around the corner, I would first shift more of my portfolio from financial assets to real assets. Within my equity allocation, I would invest more of my money in companies that have pricing power (allowing them to pass inflation through to their customers), inputs that are not very sensitive to inflation (so that costs don't keep up with inflation) and few fixed assets (to prevent the depreciation tax impact). I can think of several technology, consumer product and entertainment companies that fit the bill. As a bonus, I would like the companies to have long term debt obligations at fixed rates; inflation is likely to dilute the value of the debt. These companies are likely to see their cash inflows increase at a rate faster than inflation and will be able to buffer the impact of inflation on discount rates. In my bond portfolio, I would steer my money to short term government securities, inflation indexed treasury bonds (TIPs) and floating rate corporate notes; they are least likely to be devastated by higher inflation.

If deflation was my concern, I would invest more of my portfolio in financial assets; bonds, even with 2.5% interest rates, would be a bargain. Within my equity allocation, I would steer away from cyclical companies. At least in recent decades, deflation has gone hand-in-hand with low or negative economic growth. Consequently, I would invest in companies that sell non-discretionary products and necessities.  In my bond portfolio, my holdings will be in more credit worthy entities, since default is a very real possibility in poor economic conditions.