Once in a while I veer out of the realm of abstraction into the land of usefulness. This post is meant to be helpful for anyone currently invested in stocks. Contrary to what you might think, your stock portfolio is not a hedge against inflation. This won't be a big deal if you're not concerned about inflation. If you are, read on.
In an ideal world, stocks would be great inflation hedges. Take a business with revenues of $100, costs of $50, and earnings of $50. After inflation doubles all prices, the business's revenues now amount to $200, its costs $100, and earnings $100. Adjusting for inflation, the firm's earnings power has stayed constant. In this ideal world, a stock is a 100% inflation hedge.
In our not-so-perfect world, companies must pay taxes. This alone isn't sufficient to turn stocks into poor inflation hedges, but when we mix taxes with historical cost accounting, the distortions can be dramatic. The actual accounting details behind this may seem achingly boring, but they're worth running through at least once in your life. I'll try to make the process as hassle free as possible. If accounting just doesn't do it for you, then skip to some of the solutions I give at the bottom of this post.
The Problem
A company's tax bill is calculated based on what remains after costs of goods sold (COGS) and depreciation have been subtracted from revenues.
Lets start with COGS. When an electronics distributor sells a TV from inventory for $250, it has to match the sale of that TV with a corresponding cost. While it would make sense to take today's wholesale market price as a measure of true cost, accountants prefer backwards-looking measures and will try to match the sale of a good against its historical, or book value. Book value refers to the original price paid by the wholesaler for the TV. If the historical cost was $200, then the $250 sale is matched against that $200 cost, for a gross margin of $50.
Here's how historical cost accounting of COGS introduces major discrepancies during inflation. Say that a year has passed, prices have doubled, and our distributor is now selling the same TV today for $500. Since the distributor booked that TV into inventory at $200, the firm reports $300 in operating income ($500-$200). Quite the profit! But historical cost accounting disguises the fact that inflation will have also increased the wholesaler's true costs of replenishing inventory. After all, the wholesaler now has to pay $400 to their supplier to replace the same TV, not $200. Using replacement value rather than historical costs, the sale of a TV for $500 will only earn our distributor a $100 margin at current market prices.
During inflation, historical cost accounting of COGS provides a deceivingly rosy picture of our distributor's financial position. A healthy $300 margin is reported whereas the true margin is only $100. In accounting-land appearances can be deceiving.
This deception wouldn't be a problem, except for the fact that the firm's tax bill is calculated based on the unrealistically healthy snapshot provided by historical cost accounting, not the more accurate snapshot provided by market based costing. Remember that prior to inflation, our distributor was earning a $50 margin. Assuming that its tax bracket is 50%, that means that it was sending a $25 cheque to the government. After inflation hits, our distributor is now earning a $300 margin on the same TV. Its tax bill now amounts to a whopping $150 ($300 x 50%), an increase of 500%! This bloated tax bill is simply not merited: if we were to value COGS at market prices, it would be evident that our distributor was earning only $100 per TV, and that its tax bill should be $50, not $150. Thanks to historical cost accounting, the real value of its tax bill has tripled, even though the company's true fortunes have neither improved nor deteriorated.
The upshot is that during inflation, historical cost accounting of COGS has the effect of sucking wealth out of a company by forcing it to pay excess taxes on fake accounting profits. Inflation always makes firms and their shareholders worse off.
The same dynamic that governs COGS applies to depreciation. Depreciation represents the cost of using up capital equipment like machinery. Under historical cost accounting, depreciation is calculated as a percentage of the original cost of acquiring that machine.
Say that our distributor has a forklift that it paid $1000 for last year, and it depreciates this forklift at a rate of $100 a year. Inflation hits and all prices double. The replacement value of the forklift is now $2000 and the true economic rate at which the forklift is used up has increased to $200. Yet historical cost accounting requires that our distributor continue to use the historic $1000 cost of the forklift and depreciates it at a measly $100.
Much like COGS, this has the effect that our distributor's depreciation expense will remain unrealistically low during inflation, resulting in excess accounting profits on which taxes must be paid. Were depreciation allowances and COGS to increase with inflation rather than stay fixed at historical levels, they would simultaneously offset the rise in revenues and our distributor would not report phantom profits, nor incur unnecessary tax outflows.
Got it? In a nutshell, the combination of historical cost accounting and inflation are bad for stocks. Inflation acts as a tax increase on anyone who uses historical cost accounting. If we were to experience a series of inflation surprises to the upside over the next few years, all else staying the same it's very likely that the real value of your stock portfolio will fall. This is pretty much what happened in the 1970s, the last period of high and rising inflation. As the chart below demonstrates, the Dow failed miserably in keeping up with CPI.
It wasn't until the late 1980s, that stocks finally caught up to the consumer price index, long after Volcker had succeeded in reigning in inflation. Volcker was one of the best things that ever happened for the stock market, since by reducing inflation, he effectively reduced taxes on anyone forced to use historical cost accounting, which amounted to most of corporate America.
Solutions
What should you do if you're worried about inflation but want to stay invested in stocks? Easy. Choose companies that are less likely to suffer from historical cost corruption.
Here's an idea for dealing with the COGS problem. Accountants can choose either of two ways of measuring historical inventory costs: first-in-first-out (FIFO) or last-in-last-out (LIFO). Say that our distributor sells a TV to a customer. FIFO accounting matches that sale against the book value of the first, or oldest, TV in inventory. LIFO, on the other hand, matches that sale against the cost of the most recent TV brought into inventory. During an inflation, the most recent TVs brought into inventory will have the highest costs, which means that LIFO permits COGS to accelerate far more quickly than FIFO. This means that a firm that uses LIFO during inflation has a far lower likelihood of reporting unnatural profits and paying unmerited tax than a firm using FIFO.
Just to illustrate how important these effects can be, I'm posting a table that is taken from an early Larry Summers paper on the effects of inflation on stocks.* For each company listed in the Dow Jones Industrial Index in 1978, Summers calculated the implied percent decrease in stock value caused by the interaction of inflation and historical cost accounting. The losses due to COGS and depreciation are listed respectively. Note that the majority of Dow companies were protected from the inventory effect because they used LIFO, not FIFO. Chrysler, which used FIFO, faced an implied 49% decrease in stock price in 1978 due to +10% inflation!
So if you're worried about inflation, invest in companies that use LIFO. This won't always be easy. IFRS currently prohibits LIFO, which means it'll be tough to find the right companies. The only jurisdictions in which you will typically get firms using LIFO is the US.** Caterpillar Inc, for instance, used LIFO for 60% of its inventories in 2012. Rumour has it that the US could be putting an end to LIFO soon, so this useful investment tool may be forever dismantled. Even if LIFO does disappear, there are a few other tricks that investors can use to avoid COGS-related historical cost corruption.
How to get around the depreciation problem? You tell me in the comments. I've got a few tricks up my sleeve, but I ain't going to give them all away.
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*Larry Summers cut his teeth on the topic of inflation and corporate equities. His first few published papers deal with the issue, including Inflation and the Valuation of Corporate Equities (1978). Some are written with Martin Feldstein, including Inflation, Tax Rules, and the Long Term Interest Rate (1981). Feldstein also wrote a solo paper on the topic: Inflation and the Stock Market (1978). Note the dates on these papers. A broad literature on the topic developed in the 1970s, but now you hear nothing about the effects of inflation and historical cost inflation on profits and taxes.
**I've heard that Japan allows it too.
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