Recently, the world has been grappling with effects of Inflation.
In my previous post we had discussed in some detail, the problem of inflation and the reasons behind the recent increase in interest rates across a majority of economies round the world; including India.
Some of our learnings from the post are as below:
The Lockdowns enforced to contain the Covid-19 pandemic, caused most economies to come to a standstill.
To help people and economies recover, Governments and Central Banks across the world undertook various measures to help ease the money supply in the economy.
Governments increased public spending and also in some economies like in the USA, made direct cash (stimulus) payments to their citizens.
Central Banks, resorted to measures like Quantitative Easing and lowering of bank rates and reserve requirements in order to make borrowing cheaper.
As economies gradually opened up, we stated facing the problems of Inflation. There were several reasons for this.
The Lockdowns had disrupted supply chains across the world. The supply side issues were further accentuated by the Russia-Ukraine war. Price of several inputs; including that of crude oil shot up. With input costs rising, the prices of output supplies also increased.
Further, as interest rates were historically low, people and institutions borrowed large sums of money to spend leading to the problem of excess demand.
With Inflation touching alarming levels, Central banks had to intervene by raising the interest rates.
Inflation, Interest rates and its impact on company profitalibity:
While we have outlined the primary reason behind the recent increase in Interest rates, let us now understand how inflation as well as changes in interest rates can impact the profitability of companies.
Inflation is a situation of uncontrolled rise in prices. This happens when demand for something exceeds its supply.
If demand and supply for something remains unchanged, price will remain constant.
Now, imagine a situation when demand for something remains unchanged and, yet, its supply falls. The price will increase.
Similarly, when demand for something increases rapidly, but, its supply cannot keep pace with the demand; again, the price will increase.
Both the above situations are inflationary in nature.
As we have already discussed, the supply side disruptions (both domestic and on the international front) on account of the pandemic and the Russia- Ukraine war led to a sharp increase in the price of Inputs as well as crude oil prices.
Not all companies have been able to pass on the cost of rising inputs onto their customers. Most have seen their margins taking a hit.
Disruptions in supply chains hit some companies worse than the others. Companies facing shortage of critical supplies, could not fulfill customer orders in time; impacting their profitability.
Apart from the inflationary pressures on account of the supply chain disruptions, the ongoing increase in interest rates have also impacted companies with sizeable amounts of debts on their balance sheet.
For starters, servicing existing debt is going to become more expensive over time.
Also, for companies looking to borrow money, the cost of capital is set to increase drastically.
All this will eventually take a toll on the profitability of companies.
How to Invest in Equities in times of rising Interest Rates?
Rising interest rates call for greater caution from investors in equity markets.
Let us try and understand how we can adopt our investment strategies in times like these when inflation and interest rates are on the rise.
We have already discussed that rising input & transportation costs (on account of higher crude prices) can impact the margins of companies.
When margins get squeezed, companies with pricing power tend to perform better than the rest.
Companies offering a congeneric product/service have to align their pricing decisions to a large extent with their competitors pricing strategies
In contrast, companies with high degree of product differentiation, can pass on the costs of rising inputs more easily on to their consumers, and, therefore are in a better position to maintain their profitability.
We, as investors, should therefore look to invest in companies that have a highly differentiated product/service offering and enjoy the patronage of their consumers.
It is also important for investors to exercise great caution while investing in companies that have a sizeable amount of debt in their balance sheet.
Before making any investment in a leveraged company, investors must understand whether the company will be able to generate sufficient cash to pay the interest and principal obligations on its debt in future.
A cash flow statement is one of the most important documents that an investor must look at before investing in a company.
A cash flow statement records the sources and the uses of cash (and cash equivalents) of a particular company over a period of time. By studying the cash flow statement, we can understand where the company is generating enough cash to meet its operational expenses and debt payment obligations.
When interest rates were historically low, assuming a loan might have seemed to be the most logical thing to do. However, the real test of a company’s financial strength comes during the times of rising interest rates.
Also, investors who are invested in the banking/financial sector must look very carefully at the NPA numbers reported by the banking/financial institutions.
With rise in interest rates, NPA numbers are also expected to rise in time. This is because some companies will eventually fail to service the rising costs of debt. The impact is expected to be gradual rather than sudden.
In case of signs of distress in the reported NPA numbers, investors must look to exit the stock at the earliest opportunity.
We conclude with the golden words of Warren Buffet, “outstanding long-term results [are] primarily [achieved] by avoiding dumb decisions, rather than by making brilliant ones.”
As investors, our focus should be on risk-minimisation.
Thanks for your time!
Happy Investing!