June 18, 2008

Inflation and debt

I have been reviewing the results of some companies and a few points are standing out

- raw material cost, over heads and labor costs are now increasing faster than sales
- Net margins are stable or coming down. Profit growth has slowed
- Debt may start getting repriced soon. As a result interest costs could start increasing

Maybe this is not news. However the above has the following implications

- valuations for the market and several companies is still based on the low inflation, high growth and high ROE environment of 2002-2007. If we have stagflation (high inflation and low growth), we could see prices drop sharply.
- Some companies in response to high growth, have taken on large amounts of debt. If we have stagflation, these companies could get hit very badly. The stock price for such companies could plunge sharply.
- In contrast companies with strong competitive advantage and low debt can maintain margins due to pricing power of their products and low interest costs. Such companies may see lower impact to their stock price.

I am not predicting a long period of high inflation and low growth and cannot be sure if we will see drop in stock prices. History (mid 1990’s) gives us a clue. During mid 90’s in response to high inflation, RBI hiked the interest rates to around 15% and we had a period of low growth from 1997-1999. Stock market returns were also poor during this period.

Does it mean that we should sell our stocks and wait for the clouds to clear. I would say no. The future is never crystal clear. It never was and never will be. What we can, however be sure is that good companies, with strong sustianable competitive advantage, will do well in inflationary and recessionary times.

What such times gives us is low prices due to the pesimissm. These low prices can be used to invest in good companies at attractive prices to build a good portfolio. However this is not easy and not for the faint hearted. If the inflation drops and the growth picks up quickly , then the returns could be good in the short term. However if economic situation takes time to turnaround, then be prepared to wait for a long time for the returns to materialize.


Alisa said...

I am a first time visitor to this blog and I think it is great! I just started my investment journey into the stock market: http://www.ourstockmarketjourney.blogspot.com/

And I find that I tend to be a value investor. I agree that the strong companies that have a competitive edge, pricing power, and low debt will fair well during these crazy and uncertain economic times. These are the comananies that I am learning to identify and invest in.

Based on what I am learning about value investing, I put together a checklist of qualities that I think a business should have before being added to my portfolio. I'f love to get your feedback on my list and any guidance if I am missing anything. You can check it out on my blog.

Ninad Kunder said...

Hi Rohit

It is going to be a challenge for not just companies with high debt but also companies where growth has been factored in assuming capital raising ability like Real estate.

With interest rates hardening and the capital markets not in a great shape, capital raising will be tough. This would derail growth and contract the high PE that markets are paying assuming high growth for some of these companies.



Rohit Chauhan said...

Hi ninad
hopefully some froth will be eliminated and maybe some more bargains will come up.
Personally such markets correction are good in a way as they help in correcting over-valuations

Anonymous said...

Do you have any idea of listing Low dept company at this moment?


Rohit Chauhan said...

you can find such companies at icicidirect. use custom search option with debt/equity parameter set to <0.5 to find companies with 0 or low debt