What's up with Stonks is a biweekly report that delves into the complex and often confusing world of the stonk market. Community Manager Verneri Pulkkinen helps you navigate the troubled waters of market movements and macroeconomic phenomena. Stay tuned for the hottest investment scene news, moderate amount of stock populism and understandable information about the stock market.

In this post, we delve a little deeper into how high inflation affects listed companies. I don't think there’s much talk about this, even though the stock market is taking a beating for various inflationary reasons. If higher inflation lasts for years, the impact on stocks will be very negative.

First, some market news.

Stock markets have seen a cautious green hue, especially on the other side of the pond. The price of raw materials, such as oil, has continued to fall, which will have a cooling effect on inflation if it continues. Here is Bloomberg’s raw material index:

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A few weeks ago, interest rate discrepancies on trash loans were shrinking. It signals that the financial market situation is improving, and investors have some risk appetite again. However, the situation has taken a sudden turn. After easing from the summer peaks, the spread between CCC-grade loans and risk-free rates has started to widen again.

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Industrial orders are cooling down around the world. This graph by Renaissance Macro shows how in many countries the purchasing managers' indexes show an improvement in new orders in heavy industry. Only in 27% of countries orders are up month-on-month. This doesn't always lead to a downturn in the whole economy, because manufacturing plays a smaller role, especially in developed economies. But if I were investing in cyclical industrials, I would be a bit worried. However, the order books here in Finland are lengthy. Moreover, it is not clear from this graph whether there is a purchasing managers' index of, say, 20 economies the size of Bhutan against one economy the size of the United States. But even in the United States, new industrial orders have cooled down.

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What is the impact of high inflation on equities?

Inflation and its impact on listed companies is a recurring and important theme. Rapid inflation (a quick general rise in prices) is a poison for stocks. And especially, if it comes as a surprise, as it has now. This graph shows global inflation and the evolution of the world stock market index. The joy was cut short as inflation took off.

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Let's dive a little deeper into the impact of inflation. A certain investor has written aptly about inflation from a shareholder's perspective.

Over the last few decades, inflation in developed economies such as the euro area, the United States and Japan was so low that you didn't really have to think about it. And even if there were inflation, listed companies own real-world assets and have pricing power that would float their results at least at the same speed as inflation. Or so, you might have thought.

The afore-mentioned writer compares shares to bonds. Of course, there is a big difference between bonds and shares. Firstly, a bond has to be repaid at some point. In general, debts have a fixed interest rate. For example, if you lend the Finnish government €1000 for 10 years at 2% interest, the investor receives 2% interest for the next 10 years and then the loan is repaid.

By contrast, shares are perpetual in nature. A listed company is not obliged to pay out dividends to shareholders. On the contrary, a slice of the profits stays in the listed companies.

A bond is an undertaking by the debtor to repay a debt. A share is not a commitment, but it is a claim on the future cash flows that companies tear out of the real economy, even if future cash flows are uncertain.

Listed companies get a relatively stable return on their equity over time. In Finland, for example, the average return on equity (RoE) for large listed companies has been just over 10% for the past decade. In the United States, the 30-year average is just over 13%.

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An investor can think of a stock as a share of a listed company’s equity, on which the listed company receives a return, just as a bond pays a coupon. Another feature of listed companies is that they pay out part of their profits as dividends and part is reinvested back into the business.

Let's say, for example, that the stereotypical large company on Nasdaq Helsinki pays out half of its profits in dividends and reinvests half in its business. For example, UPM and Kemira are close to such figures. In the US, share buy backs are nowadays the most common reward to shareholders.

Let’s simply assume that the investor pays exactly the equity value of the share, no more and no less. On average, you have to pay over 1.5x the company’s equity for companies listed on Nasdaq Helsinki. This means that investors have settled for a slightly worse deal in real life.

With a flat 10% return on equity, this means that the investor receives a 10% return on the stock. 5% goes into the investor's bank account as dividends (let’s forget taxes to keep things simple), 5% is invested by the company, which means that for the same return on equity, its profit increases by 5% per year.

This “reinvestment feature” of listed companies, if you want to call it that, is quite delicious. Investors don't have to pay heavy taxes in between, and within the listed company the capital grows larger, allowing for greater cash flow year after year.

Surely it is intuitively obvious that if the interest rate on a bond is 2% and inflation rises to 10%, the bondholder is going to take a real beating. For €1,000, €100 of purchasing power is destroyed, but the investor receives only €20 in interest income. The investor's real return is therefore 8% in the red.

Remember that saving and investing your savings is about increasing your purchasing power in the future. Investors would be better off spending their money now if they cannot get a better return on it than inflation over time. Otherwise, the investor saves now so that s/he has less purchasing power in the future. That does not make any sense. Unless you get some kinds of Weberian “Protestant ethic” kicks out of saving itself.

The same philosophy applies to shares too. The investor writes that shareholders are very slow to catch on. I have to say that I have not seen too much discussion about the destructive power of inflation in investment circles in Finland.

If the real return on a bond is completely destroyed by inflation, what happens to the return on equity of a listed company? Not much better, unfortunately.

A 10% return on equity is delicious if inflation is 0%, because the investor's purchasing power increases by just that 10%, assuming that the pricing of the stock remains stable relative to its equity.

If inflation rises to 10%, a 10% return equity for a listed company and the accumulation of capital within the company no longer sounds like an attractive option. The investor's purchasing power does not increase.

Well, investors can hope for a better return on equity for listed companies. You could “safely” assume that listed companies have the muscles to raise prices in line with inflation and pass on rising costs to, say, subcontractors. Admittedly, there are some accounting elements of inflation that may initially buffer earnings and return on equity, such as the relative reduction in depreciation and amortization compared to earnings that inflate with inflation.

But this joy is short-lived, and historical experience shows that companies' returns on equity are very stable over time and they haven’t improved during high inflation.

There are only five ways listed companies can improve their return on equity.

1) To make more efficient use of capital, which can be done, e.g., through improving the inventory turnover rate. And it's difficult.

2) Companies can leverage their balance sheets with cheaper loans. However, because of inflation, interest rates are going up and financing for listed companies is actually getting more expensive at the moment.

3) You can take more leverage (it could end badly).

4) Corporate taxes might fall, but that looks extremely unlikely and instead there is upward pressure on taxes.

5) A company can try to improve its own profitability, but there's 100 cents per euro of revenue, and out of that 100 cents you must pay for raw materials, logistics, workers' wages, and overheads which are not getting any cheaper because of inflation. In addition, competitors may take market shares if a company tries to raise prices too aggressively.

The higher the inflation, the more of the return on equity it eats away of this “investor’s interest”. In practice, the ballooning costs mean that the 5% that used to go into physically increasing capacity is now going entirely into just keeping the business in place. In 10% inflation that would not be enough.

Overall, it is safe to say that while individual companies can try to improve their return on equity, as a group it is difficult for companies. The advantage of bonds is that they mature at some point and then the investor can borrow at a better rate. Stocks do not mature and much of the investors' money is locked up in the corporate system, grinding out poor real returns.

It is also good to understand that investments become more expensive in an inflationary environment. Three years ago, it was much cheaper to build a new plant because of cheaper steel, labor and other costs. Replacing old equipment with new ones costs more too. This puts enormous pressure on companies' cash flow, especially at the beginning of an inflationary period, even if reported results rise.

The value of a listed company is the present value of its future cash flows. The smaller the cash flow, the lower the present value of the company.

In this sense, listed companies with high RoEs, whose business is capital-light, and growth requires less investment, are stronger in an inflationary environment.

In addition to the low cash flow, the investor's required return is unlikely to remain unchanged. If interest rates now rise, investors will no longer be satisfied with the typical 7-10% required return on stocks. This is a radical example, but if an investor still wanted a 10% real return on the company that has a 10% return on equity, s/he should only have to pay half its book value for its stock. In other words, the stock would have to collapse by 50%.

Or the company would have to masterfully get its return on equity up to 20%. Note that even then, in terms of P/E, you only have to pay 5 times the earnings of the company as opposed to the previous 10. But hey, at least the share price doesn't have to halve.

Taxes always sting, but in an inflationary environment they are downright painful. Let's imagine that investors do indeed receive a nominal dividend yield of 10% from the same listed company because the share halved or the return on equity doubled. The retail investor pays roughly 25% of this nominal return in taxes, which means that the dividend yield is actually 7.5%. Inflation is 10%, so in reality the investor receives virtually no dividend at all, but still pays tax. Just how lovely is that?

Fortunately, in real life, 10% inflation from now until forever is not a baseline scenario; in fact, it seems extremely unlikely. Currently, the market expects inflation to ease in the coming years. In raw materials, for example, prices are cooling down rapidly at the moment. US 10 year breakeven has come down a bit.

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Stocks are by nature an asset class that you have to HODL for a long time, so it is more relevant for an investor to think about what inflation would look like in the next 10-20 years, not what it looks like right now. However, if for one reason or another inflation remains at a higher level than before, there will be the kind of downward pressure on stocks that I described.

Oh, and the investor that I mentioned earlier in this post is Warren Buffett, who wrote a brilliant piece on inflation in Fortune magazine in 1977. I guess he was already a boomer back then, as just a short while ago he turned 92 years old. The text is just as valid today as it was then.

Thank you for reading the post! Read analysis and make good stock picks!