views
What is City Talk? Info Info. Latest

Why does inflation tend to be good news for value investing?

 
Kevin Murphy
Follow Kevin
A picture taken 17 April 2007 in London...
Prices are rising which can help value investors (Source: Getty)

‘Value investing’ has been resurgent since last summer, as explained here. Inflation can help this type of investing. Kevin Murphy, an author on The Value Perspective blog, explains why.

At the very end of last year, in our post Three important investment lessons to take from 2016, we noted in passing that President Trump’s intention to spend a lot of money on infrastructure would lead to inflation, which “for a variety of reasons tends to be good news for value”.

Revisiting that piece recently, it struck us the connection between inflation and value is not necessarily self-evident so let’s consider it more closely now.

We have discussed before, in articles such as Beware ‘style drift’, how there are two broad styles of investing – value and what is often known as ‘growth’.

A crucial difference between the two camps is the length of time before you might expect to make your money back – value investors do so more quickly by virtue of buying businesses in which the wider market has low expectations.

Thus, if you were to spend £100 buying into a value business on a price/earnings (P/E) ratio of 5x, say, that multiple suggests your shares should make £20 a year in profits, and so you will ‘get’ your money back after five years.

In contrast, a growth business is likely to have a high P/E ratio, which means low profits today, but growth investors pay up in the hope of making their money in, say, years 16 to 20 rather than the first five.

In financial-speak, that makes the value business a ‘short-duration’ asset and the growth business a ‘long-duration’ one.

Still, irrespective of the fancy jargon, the important practical point is that, in an inflationary environment, money now is worth more than money further down the line. The further into the future the money is, the less it is worth. It is for this reason that value, which sees investors recoup their money sooner rather than later, is more attractive in an inflationary world.

Over the course of the last seven years or so, however, investors have been far less concerned about inflation than they have about deflation. Usually, prices of goods and services head upwards over time (that is, they inflate), and so £1 buys you progressively less the further out you look into the future.

In times of deflation, however, prices of goods and services head downwards, and so your £1 buys you progressively more goods or services the further out you look. It is for this reason that growth businesses, or those with a long-term stable franchise, are prized significantly more highly than value ones in a deflationary environment.

This is why growth businesses, and particularly high-quality companies with pricing power – the so-called ‘bond proxies’, such as food, beverage and tobacco groups – have been such great performers of late.

It is also why, should you believe inflation is making a comeback – and of course we are not offering a view on that, one way or the other – it would unwind a significant proportion of value’s recent underperformance.

  • Kevin Murphy is an author on The Value Perspective, a blog about value investing. It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction.

Important Information: The views and opinions contained herein are those of Kevin Murphy, Fund Manager, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The sectors and securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.

Related articles