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.
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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.
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