Quality Investments for a Stagflationary Environment

Quality Investments for a Stagflationary Environment

Director of Investments Daniel Dusina, CFA® was recently quoted in this article from U.S. News & World Report titled ‘7 Best Stagflation Stocks to Buy in 2023', and wrote this blog post as a follow-up piece with his full thoughts:

Stagflation is characterized by an economy that exhibits persistently high or increasing inflation coupled with elevated levels of unemployment and weak demand for goods and services. The term itself is a result of blending stagnation in economic growth (stag) and inflation (flation). Stagflation is counterintuitive, as one would expect demand to be strong and unemployment to be low during periods in which prices are high or rapidly increasing. Essentially, stagflation equates to an economy that is in a recession, but exhibits high inflation. Stagflation is difficult to tackle from a policy perspective, as actions that aim to counteract inflation (i.e., higher interest rates, decreasing the money supply) may exacerbate the level of unemployment.

The three components of a period of stagflation (high inflation, high unemployment, and weak demand) have an impact on revenue, profitability, and valuations of businesses, which in turn can impact the price an investor is willing to pay for a share.

Starting with the top line (revenue), high unemployment and weak demand leads to less money coming in the door for businesses. Whether this is t-shirts, electronics, or household goods, consumers will tighten their pocketbooks given a weak labor market equates to less certainty about future income.

Down the income statement, high inflation indicates that input costs experienced by businesses will be elevated. Combining downside pressure on revenue with upside pressure on costs, businesses are likely to experience compression of profitability in periods of stagflation.

With lower current earnings power and less certainty about the future earnings power of publicly traded businesses, both trailing and forward valuation multiples (such as price-to-earnings) will appear stretched as investors will be paying more per share relative to a firm’s profitability. This will lead market participants to sell stocks until prices are more closely aligned with the earnings power of the underlying businesses. In fact, equity investors may shed their allocation to equities to an extreme degree (i.e., push valuation multiples below historical averages) given uncertainty around the time frame that stagflation will persist.

Equity sectors that have historically been resistant to stagflation

During the period of stagflation in the 1970s, real estate outperformed the broader equity market. As to why, there are three items that investors can look to in order to understand why this sector may have fared better than the rest.

1. Costs:

Real Estate Investment Trusts (REITs) can pass through the broad cost increases that inflation brings by resetting/rolling leases or through built-in escalators.

2. Values:

During periods of inflation, real estate asset values increase, as replacement costs can be 2-3x that of the inflation rate.

3. Profits:

Given better cost control, REITs can experience growth in net operating income (or NOI – a measure of profitability for REITs) while businesses in other sectors may experience declining earnings.

In periods with just inflation, REITs with short-term lease duration should fare relatively better as they can reprice rents more frequently. For example, hotels reprice on a daily basis while multi-family residential properties generally roll leases over once a year.

With stagflation, however, high unemployment and waning demand make it unlikely for individuals to shell out excess cash for vacations. Even multi-family residential property owners may be challenged as tenants a faced with budget constraints. The cell towers and data centers subsets of real estate, however, can offer strong value propositions in periods of stagflation. Cell towers lean on the defensive telecommunications industry as clientele, and given the “mission critical” nature of the businesses, cell towers can counteract the issues stagflation poses to other REITs. For data centers, the cost of power required to fuel operations is a major expense. Having said that, data center operators have generally passed on the majority if not all power cost increases down to their customers, which positions the subset well for periods of stagflation.

Metrics that stagflation resistant companies possess

1. Inelastic demand:

Given stagflation is partially the result of lower demand, companies who offer products or services that consumers and businesses cannot forego are well positioned.

2. Cost control:

Getting the money in the door is the first step but translating that revenue into profits is important if a business is to fare better during a period of stagflation. The ability to pass through increasing costs to end consumers/clients is imperative should a company be faced with stagflation.

3. History of consistent profitability:

Consistent profitability indicates that a business likely has some level of inelastic demand, whether it be through competitive advantages or positioning in a concentrated industry. Generating a consistent and growing level of earnings and free cash flow through different types of adverse economic environments also indicates that management has their operation focused on prudent capital allocation. At the end of the day, past performance is not indicative of future results, but history should certainly be considered.

The big picture

To be certain, a stagflationary environment poses unique challenges for investors. Increased scrutiny on company financials is paramount, as is an updated view on the competitive insulation of businesses across the equity market. Having said that, stagflation is not imminent. Inflation has been choppy but is trending down, U.S. GDP was +2.7% in 2022, and domestic growth is expected to remain in positive territory for 2023. Having a playbook for various underlying economic environments is prudent, as is continuously incorporating fresh economic data so as not to put the cart before the horse.