Stocks the best hedge against inflation

Our brain always takes short cuts while processing information, which results in flawed thinking and faulty decisions. We make our decisions based on the most readily available information or recent events. Here newspapers and other media play a big role in the way we think.

At present, the stock markets are rising, along with a host of good news coming in. No doubt liquidity is playing a major role, leading to inflation. We have a rise in all asset classes, thus an erosion in the value of money. As soon as there is news of inflation rising, the markets react with fear, causing a dip. Should these news cheer us up if we are stock investors? In such a situation, what is the best form of investment?

If you have fixed-income investments, you are a sore loser. Inflation will not only eat into your purchasing power, but also erode your capital. Fear makes you look for returns of your capital rather than returns on it.

Gold and silver are in the limelight. But one cannot have steady returns on them, except for capital appreciation. Real estate is good, but is not divisible and out of reach for many people.

Stocks are the best form of investment in a rising inflationary situation. But why stocks? Stocks represent ownership interest in a company. The company is in the business of selling a product or a service at a profit. Out of the said profit some is distributed to the shareholders by way of dividend and the rest is ploughed back to grow the business. The company owns land, machinery, buildings, brands, patents, goodwill and employs knowledge workers. When inflation is rising, the company has the power to raise prices. Moreover, the value of its assets goes on increasing. The replacement cost theory is at work. This makes it expensive for new entrants in the business and be price competitive. In a rising inflationary situation, stocks are the best.

The choice of stocks is very important. First and foremost is understanding that buying stocks is equivalent to buying businesses. These businesses need to have certain important characteristics: the least amount of capital required, no or negligible debt, a good and a strong moat around it like a strong brand, a good distribution network, patents, monopoly, a sustainable cash flow stream and a good business model. Above all, such businesses need to be run by a credible management which respects the minority shareholders. Management plays an important role in how safe the investor’s money will be. Once the choice of business is completed, it is the price we pay that is important. Are we paying the right price? Are we buying a ‘value’? Values are available in bear markets or when bad things happen to good companies or when companies and sectors lose investor fancy.

Markets offer such opportunities from time to time if you have the patience and the courage to go against the current fancies and popular trends.

The writer is chairman, Parag Parikh Financial Services. Views expressed are his own