Damn you inflation!!

I was having such a happy time!. The economy was growing at 8%, midcaps and small cap companies were showing great increases in profits and the stock prices were following suit. The India growth story was coming true and due to my brilliance in recognizing it, my portfolio was up a billion percent from the 2009 lows. At the current rate, I could have retired soon. Damn this inflation !!

I am joking and being sarcastic.

Investing in inflationary times
If you follow the talking heads on TV and the self appointed gurus, then according to them you need an investing strategy for inflationary times, one for recessionary times, one for summer and may be one when it is cloudy in Timbuktu. I am in a real sarcastic mood :)

We have people recommending gold, silver, oil and all kinds of commodities. The time to buy commodities was 2009 when the world economy was in a ditch and not when everyone and his dog knows that commodities have gone up by 50% of more and are approaching peak levels

So what should one do? I cant speak for others, but I am not doing anything different from what I have always done – indentify good companies and buy them at a margin of safety – with emphasis on ‘margin of safety’

I often get asked – Company XYZ is a good company and growing rapidly. It sells at a high valuaton, but then the future is bright, so why not buy the stock?

Do you notice the assumption here?

‘The future is bright’
No one knows about the future. That is as close to a certainty one can have (not withstanding the claims by the gurus on TV). Did the market know that the world economy would fall off the cliff in 2008 or that inflation would spike in late 2010?

So how does one guard against the future – by insisting on a margin of safety when purchasing a stock. I will not buy a stock unless it is undervalued by a decent margin.

But, I did buy at a discount !
You may have valid point, that when you looked at a company, it appeared cheap based on the last few years of data. I have seen most of the people analyze the last five years of data and make a decision. Even I did that a few years ago.

The problem with looking at a short history is that one can miss some part of a business cycle completely and not realize how the company will do in that period.

An example
Lets look at an example to illustrate the point. I recently analysed construction material companies – visaka and Hyderabad industries.

Following are the net profit margins for visaka for the last few years
2005 - 6.9%
2006 – 6.5%
2007 – 5.5%
2008 – 1.8%
2009 – 6.3%
2010 – 9.5%
2011 H1 – 8.5%

There are a few things which stand out. The company’s margins have fluctuated a lot of in the last few years between a low of 1.8% to a high of 9.5%. The first point of analysis is to dig further and understand what was driving these margins.

If one analyses deeper, one can see that 2008 margins dropped due to a spike in raw material prices in 2008. So that gives a strong hint on how the company will perform in an inflationary environment.

2010 was a high in terms of margin and growth for the company. It is quite possible to assume that the company has reached a higher level of profitability. However if you dig deeper, you will find that there is no a particular reason in this industry for any particular company to have a much higher margin than others.

In addition, the other major companies like Hyderabad industries also had a cyclical high in profit margin in 2010. So the demand supply situation was favorable for the industry as a whole and the company was enjoying a nice tailwind

The 20/20 hindsight
It is easy to be brilliant in hindsight. You may be thinking – now this guy is telling us that he knew what was coming.

On the contrary, I had no clue whether the inflation would go up or not. My approach is to look at the last 10 years of performance and arrive at the margin range. In case of visaka, I assumed 5-7% for the company. At a normalized 7% margin, the company did not look very cheap.

So now what?
Things are never as good or as bad as they seem. The market may be over reacting to this whole inflation thing and this in reality is a good thing as several good companies may soon start approaching attractive valuations.

The key is to indentify such companies beforehand and then wait patiently for the market to offer an attractive price. It may soon be time to open up the wallet