Can stocks really beat inflation?

Governments are busy fighting recession, central banks are busy printing money, and investors are busy getting scared of impending inflation. It is widely expected that with the current loose monetary policies being employed, those dreaded inflationary times may turn out to be just around the corner.

The slow rise in the WPI (wholesale price index) in recent months has just been adding to the anxiety.

So as investors scramble for shelter, the million dollar question these days seems to be "Which investments can provide the best shield from inflation?" Stocks are widely cited as one such asset class that can help achieve the above objective.

But exactly how and why should stocks help beat inflation? Are they better than conventional fixed income (or debt) instruments in this respect? We will seek to address those very important question in this article.

At the most basic level you will notice that companies in general tend to achieve higher returns on shareholders capital than pure debt instruments do. For example, a safe debt instrument may currently give you returns of about 7 per cent to 8 per cent. But a good company may consistently be able to achieve a return on equity 15 per cent or more.

However, it has been observed that companies are not usually capable of increasing that return on equity to higher levels in times of high inflation.

But the fact would remain that, inflation or no inflation, you would usually get a higher return by being in a good business than in a debt instrument. So that's how equity returns can be potentially higher.

The big caveat here is the importance of entering the businesses at the right price. This is because if you enter at too high a price, you stand the risk of being at the mercy of the whims and fancies of the stock market as you would find yourself too far removed from the fundamentals of the business.

Take, for example, the years 2007 and 2008. The consumer price index rose 6.3 per cent in 2007 and 10.7 per cent in 2008. Imagine if at the start of 2008, in January, you had decided to make your investment decisions.

Expecting inflation to be high for the rest of the year you bought into the index at the time. Now, a little under two years later, let alone beating inflation, you would actually be staring at a loss on your investments instead.

Additionally, as far as stock prices are concerned, another thing you should keep in mind is that governments usually increase interest rates to contain inflation. And a rise in interest rates usually imposes a downward pressure in stock prices as that decreases the present value of the future cash flows that are expected from the business.

Also, people tend to shift to debt instruments when the gap between interest rates and return on equity for companies narrows, thus further causing stocks prices to go lower.

All in all, keeping all the above in mind, it is probably the best strategy to invest in good companies for the long term when they are available at prices that make sense.

And if you have indeed chosen your company wisely and have not paid too high a price to buy a part of it, you can indeed expect compounding to work in your favour and a great overall return over the long term. Inflation or no inflation, that would surely be a good position to be in!