Inflation: Should You Stick with Growth Stocks?

As economies begin to reopen and claw back from the trenches of the pandemic, one factor which seems to be bugging investors is the rise of inflation. Pent-up demand, shortage of labour, supply chain bottlenecks, and the Fed’s monetary policy have sent asset valuations skyrocketing. The price of commodities such as oil, copper, and lumber are hitting record highs. Consumer staples such as corn, wheat, and sugar have also spiked up sending the prices of household items upwards.

Historically, the stock market has always correlated negatively with inflation. This implies that as inflation levels rise, the value of stocks tends to go down. Though stock indexes tend to outperform inflation in the long term, in the short-run, stock prices would be ticking lower. Rising inflation increases the cost of production which tends to be passed on to the final consumers as increased shelve prices.

High inflation can be good, as it can stimulate some job growth. But high inflation can also impact corporate profits through higher input costs. This causes corporations to worry about the future and stop hiring, reducing the standard of living of individuals, especially those on fixed incomes. This reduces the number of sales, squeezes profits, and ultimately reduces stock returns.

As investors, it is worthwhile to know how your portfolio would perform as the shadow of inflation looms over the economy. This is because real gains on stocks would be subsidized due to lower purchasing power. As such, it pays to know how best to structure your portfolio to die the inflationary wave.

One area of the market which would be seeing much activity as inflation ticks up is growth stocks. This article looks at growth stocks, how inflation affects their performance in the market and how you should play them in such an event. Let’s dig in.

What are growth stocks?

Growth stocks are shares of companies that are expected to grow at a significantly higher rate than the market average.  These companies possess some form of a competitive advantage which they exploit to outperform competitors and the industry average. Growth companies reinvest earnings and revenues to accelerate growth and as such do not pay out dividends. Investors in growth stocks are compensated by capital appreciation over time, though initially, they may be trading at high multiples which makes them expensive. 

How does inflation affect growth stocks?

Because investors are discounting future earnings at present value when investing in growth stocks, inflation tends to trigger a sell-off in these stocks because money is worth more in the present than in the future during inflation. 

Growth stocks tend to have a longer duration than value stocks because they have their earnings farther out. Investors in growth stocks forecast the current value of future earnings will be.  When inflation or interest rates start going up, it erodes the current value of the future stream of earnings. This implies they would get less value for their investments in the future than in the present. 

For example, if you were to spend $1000 buying into a value business that trades at five times multiples (5x P/E ratio). This implies that your shares should make a $200 profit in a year in profits, and 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.

Also, inflation tends to chip off the further earnings of growth companies. Due to rising production costs, this would increase the price of finished goods. Consumers by nature would navigate to cheaper alternatives (if the product is elastic) or reduce the quantity purchased (if the product is inelastic). 

As such, given the above reasons, holding growth stocks during periods of inflation may be a bad investment choice (in the short term). Apart from the reduction of further earnings, the share prices of growth stocks are known to plummet when inflation and interest rates go up as investors would rotate into commodity-backed equities and value stocks whose companies would benefit from higher production costs. 

Secondly, since value stocks have present cash flows, they stand to fare better during the inflationary period because the value of the cash would decrease in the future. This is why analysts and industry watchers call value companies a ‘short duration' asset, while growth companies are referred to as ‘long-duration’ assets. 

How to invest in the stock market during inflation

The market is yet to find a panacea when it comes to inflation. As such, investing in the market during such a period can be tricky especially if the overall sentiment is bearish. There are two approaches to investing in the stock market depending on your investment horizon. 

If you are more of a short-term player, tend you should rotate into value stocks. Since value stocks generate cash flows, and as explained earlier cash is more valuable in the present than in the future during times of inflation, this inevitably means that value stocks would incur more value during inflationary periods. 

However, if you have a long-term view, then inflation may be a buying opportunity for growth stocks. The premise of this argument stems from the fact that stocks tend to outperform inflation in the long term. Growth stocks as explained previously are long-duration assets, whose future earnings are discounted for present value. 

 Due to the sell-out which would impact growth companies, the stocks would be decline to cheap levels which can produce astronomic returns if held for long periods (provided fundamentals are alright)/

You can use strategies such as Dollar Cost Averaging to take and maintain positions in growth stocks which are sure to tick upwards as inflation subsides. Apart from getting high-quality growth stocks at cheaper prices, investing in growth stocks during the period of inflation also puts you a step ahead of the market. While concentration would be in value companies, the lack of activity in growth areas would present good opportunities to take up position before the market rotates back to growth. 

If you do not have an iron stomach to weather the inflationary storm as your portfolio may be bleeding red if you are invested in growth stocks, you can invest in commodity-backed equities, REITs, and industrials (which are value companies). 

Conclusion

Holding on to growth stocks during inflation is frowned upon by analysts and industry watchers. In an inflationary environment, cash is worth more in the present than in the future. The further into the future that money is, the less it is worth. This is the reason that underpins the rotation into value during inflationary times.

 However, you should have it at the back of your mind that investing is a marathon and not a sprint.  The savviest investors are those who can stay ahead of the market and are the patience to see their strategies fall-through. While not everybody would be willing to hold a position in a stock for a minimum of two years, this is where the wheat is separated from the chaff when it comes to stock investing. If you have a long-term view to investing, then holding your growth stocks can be a good move. 

Alternatively, you can trim your positions and renter at lower price levels. You can also decide to average down on your growth portfolio which ultimately reduces the average price of your shares. 

Since the S&P 500 has historically outperformed inflation, maintaining your position and riding the wave of inflation would have a bigger payout in the future. As such, sticking with growth stocks may leave a gory site for your portfolio, but if you can stomach the fear and uncertainty in the market, and realize that your losses are only in paper until you have sold, you may be setting yourself up for a more profitable future.