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Which shares could help combat inflation?

How inflation impacts businesses and which sectors to consider if you think inflation is on the way.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

At the moment inflation and deflation are both possibilities.

Unprecedented government spending, low interest rates, and central bank actions are key components of the inflation argument. But high unemployment and longer-lasting disruption caused by the coronavirus pandemic point in the other direction.

There are lots of moving parts in this debate, so rather than predict we’ll help you prepare.

This article is not personal advice. If you’re unsure, please seek advice. All investments fall as well as rise in value, so you could get back less than you invest.

How does inflation impact businesses?

Inflation is a measure of how much prices have gone up over time. It also reflects the rate at which cash becomes less valuable – £1 this year will get you further than £1 next year. The Bank of England currently targets 2% inflation, which is the theoretical minimum your cash or investments need to grow each year to stop them falling in real value. Central banks have struggled to hit their target recently.

When discussing inflation economists distinguish between “nominal” prices, which is the price before adjusting for inflation, and “real” prices, which are after adjusting for inflation.

Inflation affects everything from the price of raw materials to wages. But it also affects the value of a company’s assets and liabilities. Inflation increases the nominal value of a company’s tangible assets like plants and machinery, while the nominal value of any fixed debts stays the same.

Here’s a simplified example of the impact of 2% inflation on a company’s balance sheet. It boosts asset value while leaving debts unchanged, with the net effect that shareholder equity increases.

Before inflation After inflation
Assets 100 102
Liabilities 50 50
Equity value 50 52

Which businesses look more attractive in times of inflation?

Capital intensive sectors like mining, utilities, automotive manufacturing and energy, tend to benefit as inflation boosts the value of their assets while reducing the cost of debts. Businesses with a strong brand can also be a good option – they tend to have the pricing power to pass on rising costs to customers.

Miners

Bringing new commodity supplies to market doesn’t happen overnight.

Exploration and building the basic infrastructure can take years, so by the time production is up and running a lot of the costs are out of the way. In times of inflation this works in a miner’s favour. By the time the commodity is ready for sale its price has increased. Higher than expected sale prices, from investments made when prices were lower, means higher profits.

It’s important to remember that miners are price takers. With commodities affected by a whole host of supply and demand factors, prices tend to be volatile.

However, this can be less of an issue for big diversified miners like BHP. Once set up, ongoing costs tend to be stable, and are low enough that it would take a significant drop in prices to get close to breakeven. Last year iron ore (which makes up most of group profits) unit costs were close to $12 per tonne, but the average selling price was $77.

The high upfront costs that come with mining mean it’s a sector familiar with debt. While we’re not usually advocates of highly indebted companies, there could be some benefits if inflation strikes.

As assets rise in value and debts remain stable, the ratio of debts to assets falls. This gives the miner room to borrow and invest more, if it sees productive opportunities.

Automotive

Whether you’re manufacturing a Ford or Ferrari it’s an expensive process, which means, like miners, car makers fixed assets tend to benefit from periods of inflation.

But there are a few other reasons why Ferrari offers more than the average auto investment.

When you’re paying over $200,000 for a car, you’re probably not that sensitive to the price. Which is why the group provides a good example of how brands with pricing power tend to suffer less in times of inflation – Ferrari is also likely able to pass on their rising costs to buyers.

Profit margins are a useful way to gauge whether a company has pricing power or not. At 24%, Ferrari’s 2019 profit margins look more like a luxury fashion brand than a car maker. At just over 3%, Ford’s on the other hand, do not.

In times of inflation highly competitive markets, like the one in which Ford operates, will find it harder to pass on higher costs to customers – which will likely see its margins squeezed further.

Ferrari’s enviable position has been recognised by investors. The shares change hands for 45 times next year’s earnings, significantly above its average of 31. A change in sentiment towards the business could have a huge effect on the current share price.

However, we think this acts as a good reminder that while capital intensive sectors may offer investors inbuilt shelter in times of inflation, finding a good business at the right price could be one of the best shelters.

Learn more about the value of investing versus cash

Unless otherwise stated estimates are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments and income they produce can rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.


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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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