Wednesday, May 15, 2013

A stock portfolio is a bad hedge against inflation

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.


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.

*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.


  1. "Inflation always makes firms and their shareholders worse off."

    That isn't true JP.

    There is a good argument for a mild inflation in a section (chapter?) titled "The Case for a Gently Rising Price-Level" by Dennis Robertson from his 1922 book "Money".

    1. Implicit in my argument is the assumption that no one suffers from money illusion. If no one is tricked by nominal price changes, the fact still remains that structural rigidities due to historical cost accounting introduce an important non-neutrality. Firms are force to pay excess taxes on non-existent profits.

      There are probably all sorts of stylized arguments you can make if you reintroduce money illusion. But that would be a different post. I'm more interested in nailing down tax effects here.

    2. Don't think the argument depends on the existence of money illusion.

      I agree with you about general analysis except that it isn't the case that inflation always makes firms worse off because mild inflation is better for firms than a situation with zero inflation and/or deflation.

    3. When I responded it was after looking up the Robertson reference. The section you refer to has some money illusion-ish things going on:

      "Of course the stimulus of rising prices is partly founded in illusion. The salaried official and the Trade Unionist have been beguiled into accepting employment for a lower real reward than they intended. Even the business leader is the victim of illusion : for he is spurred on not only by real gains at the expense of his debentureholders and his doctor and even (with a little luck) of his work people, but also by imaginary gains at the expense of his fellow business men."

      I don't deny that these sorts of things can occur. I suppose its the tax effects that I find most interesting since I assume them to be more regular and consistent.

    4. Ramanan,

      It is not true that firms are better off with mild inflation than zero inflation or deflation. As long as firms' expectations of future inflation/deflation are accurate (i.e. no firms are suffering from money illusion), then it doesn't matter what the actual future inflation rates will be. Firms will invest in the present accordingly, given those (assumed correct) expectations.

      The problem of course is that perfect foresight is a chimera. Nobody can know for certain how a given OMO from the central bank will affect their own particular nominal incomes, and when. The only reason mild inflation *seems* to "work", is because of money illusion. But as I am sure you realize, any investment activity founded upon money illusion will not be solely representative of actual consumer preferences. It will be a combination of preferences and the price and interest rate effects of inflation that arise apart from real savings patterns. This generates malinvestment and recessions/depressions.

  2. Can firms use payment in kind to avoid the bad effects of historical cost accounting? Or could they use a different currency, one less prone to inflation, and do their accounting in that currency?

    1. I think so. Payment in kind can be easily kept off the books, hiding profits.

      Accounting in a different currency, or accounting dollarization, is also a way to remedy the problem. (Here's another interesting article by the same author.)

      There may be laws and traditions that make this switch difficult.

  3. And FIFO would be a similar hedge against secular deflation, right?

    1. That's right. As I was writing this I couldn't help wonder how much of the huge increase in corporate cash hordes, and the decline in government revenues, has been due to the combination of FIFO and lower than expected prices.

  4. JP,

    It seems to me that the "weighted average cost" method is allowed under IFRS.
    Therefore, following your solution, it would also mitigate inflation risk to invest in companies using the weighted average COGS method rather than in those using the LIFO method, if you want/have to invest in IFRS companies.

    1. Yes, if you think inflation will rise, investing in companies that use weighted average cost accounting is better than those using FIFO. LIFO is still the best, assuming the jurisdiction in which you invest allows it.

    2. Sorry, my post should have read "to invest in companies using the weighted average COGS method rather than in those using the FIFO method", not the LIFO method!

      LIFO is still the best method in this situation.

  5. The TV is almost a distraction in the example:

    Imagine your company starts $200 in the bank and the natural real rate is 5% and the tax rate is 50%:

    If inflation is expected to be 0% and realizes at 0%, a year later, the company has $205 after collecting interest and paying taxes, and they're worth $205 starting dollars.

    If inflation is expected to be 100% and realizes at 100%, a year later, the company has $315 in the bank after interest and taxes, and they're worth $157.5 of the starting dollars.

    Taxation of capital is "unfair" when it comes to inflation.

    However, one in effect you haven't mentioned is that if the state doesn't spend anymore in real terms than it used to, it has no use for the extra tax income so it could lower the tax rates which would at least partially offset the additional burden. Yeah, I know.. I'm dreaming...

    1. If the economy-wide expected real rate of return is positive, I don't think a company would accept an interest rate that resulted in a real loss. Say the natural interest rate is 5%. Companies will require that the bank provide them with a nominal rate sufficient to compensate them for any expected rate of inflation such that the net real return is 5%.

      But I do like your point on Ricardian equivalence. That certainly introduces some interesting twists.

    2. Now you've got me completely confused :)

      If the company has capital, it will attempt to get the best possible return on it (given its risk tolerance), whether the after-tax return is positive or negative..

      In this situation, there's nothing the company can do to get around the real loss..

    3. After some sleep, I see now what your point is. A company that puts money in the bank is taxed on the nominal interest return they make, not the real return. So at 0% interest & 0% inflation, firms are taxed on a nominal 0% return and end up at where they started. But at 100% interest & 100% inflation, they are taxed for the 100% nominal return, despite earning nothing on a real basis, and therefore end up with less.

      Let's say the tax system was changed to prevent taxation of fictitious capital gains. Companies and their shareholders would still suffer from the historical cost effects (COGS + depreciation) that I talked about in this post. In other words, we're talking about several different interactions between inflation and taxes.

  6. JP,
    Having been an analyst for Latin companies in the 90's, I can shed some light on an additional reason for inflation hurting P/E multiples. Inflation tends to affect relative prices, and sometimes in a volatile way. Abrupt changes in relative prices make profit margins volatile. A business facing high and variable inflation will thus find it hard to forecast returns to long-term expansion projects. Instead, they tend to look at inflation-driven arbitrage opportunities, such as increasing working capital (i.e. extending days receivable, pre-buying inventories, etc) and buying foreign exchange. The net effect of all this is that long term investment stagnates, and with it real growth. As a result, P/E's decline.

    1. Fascinating stuff, Diego. You must have learned a lot from your experience. The presence of inflation surely adds a whole extra dimension to security analysis, one that we simply don't grasp or appreciate in North America.

  7. As far as the depreciation expenses go, I'm guessing an investor would prefer geometric to straight-line depreciation for tax reasons (expenses are front-loaded under geometric and the company thus gets more money in more present and time valuable ways)

    Other than this, I'm stumped. High turn-over?

    1. Accelerated depreciation will somewhat mitigate inflation tax effects. (See here and here). Replacement cost depreciation will help shield from the effect too.

      High turnover should help shelter from COGS effects, since costs get updated more quickly, saving the firm from the necessity of using stale and lower costs.

      Another way to approach the problem is to think about what sorts of businesses don't have much depreciation to begin with, since these businesses will be less likely to pay excess taxes during inflation.

  8. If all inventory (and receivables) is financed (at floating, current rates), does it matter (ie debt is indexed to inflation)?

    Slightly off-topic: a few years ago I tried to check whether the US NIPA accounts for corporate profits compensated for this effect (i.e. CPATAX series). I found some vague citations that it used to be historic cost accounting and then it changed in ~1969(?) to replacement value accounting; but it wasn't clear whether the whole series is the latter. Anyone know any references to that?

  9. Invest in companies with pricing power relative to their customers and suppliers. In an inflationary environment, this kind of company can raise prices on its customers more than its suppliers can raise prices on it. This does not solve the tax problem, but can offset its impact on the bottom line. Buffett outlined this in one the Berkshire annual reports from late 70's or early 80's.

  10. What would be the best way to profit from a high inflation? Long stocks, short bonds or short currency?

  11. IFRS applies only to financial reporting. Taxes (at least in the US) are determined by IRS rules. Companies do keep separate tax and financial accounting books. And it is quite possible to have FIFO for your financial reporting and LIFO for your tax reporting, thereby minimizing the impact of inflation on taxes.

    As for capital investments, the issue is complicated by accelerated depreciation and other tax incentives that change the tax depreciation profile quite significantly from the historical depreciation profile.

    Ultimately, the higher tax liabilities can be viewed as a tax on the inflationary capital gains on assets. So, to the extent that taxes eat away part of the inflationary gains, stock are indeed an imperfect hedge, but they are still an hedge.

    I am really not sure what data Summers used--I am generally skeptical of economists when they use financial data, they are often blissfully unaware of the difference between tax and financial reporting. (I speak from personal experience and I am an economist who happens to have training in accounting.)

    Secondly, are you talking about a permanent rise in the rate of inflation or a temporary surge that may last for a while but will eventually subside? Because the implications for dividend discount model are different for each. Also, you have completely ignored the fact that inflation reduces the likelihood of default--after a stock is a call option on the assets of the firm and the delta of the option with respect to the inflation has to be positive.

    The issue is quite complicated because it is generally difficult to isolate inflationary episodes that are also associated with political turmoil and heightened uncertainty, both of which undoubtedly weigh on stock valuations.

    So, really if the question is are stock an good hedge against troubled times with inflation, then the answer is no. Are stocks a good hedge against inflation with complete tranquility otherwise? The answer is we don't know because there are no such periods in history.

    1. You bring up a good point that it is the tax books that are the relevant variable, not accounting books as dictated by IFRS. The IRS allows LIFO, for instance, whereas Revenue Canada doesn't.

      I did ignore the fact that inflation reduces the real value of debt and interest payments, as you point out, therefore cushioning the negative effect from COGS and depreciation. The Summers paper finds that the debt effect was not sufficiently strong to fully compensate investors.

    2. I checked with one of my accountant friends and he said that I was wrong--the IRS code mandates that if you use LIFO for tax purposes then you have to use it for financial accounts as well.

      On a separate point, according the NIPA, "inventory profits" accounted for nearly 15% of pre-tax corporate income (for nonfinancial corporations) in the decade of the 1970s compared with the 50-year average of about 5%. So, a huge portion of the profits in the 1970s was simply not "sustainable" and investors would have seen through it. I think the tax angle is relatively minor--the accounting literature's findings are mixed on the tax angle.

  12. JP,

    I've followed your comments on MacroMania and Free Advice, and I like your blog. I feel I have something to add here, since I've done research on this topic. It is true that in countries where inflation has been low and steady for a long time (e.g. US, UK, Canada... most industrialized countries) stock returns do not adjust for inflation (contra Irving Fisher). But, when inflation is high and/or volatile, investors do appear to require compensation for equity investments, and stock returns include an inflation premium. What is at the root of this I didn't study, but I think it's possible that when inflation is low and stable, people don't notice it and therefore don't require the compensation.

  13. Here's something I wrote a couple years ago on the issue:

    1. Prof J, thanks for stopping by. I like your point about investing in Israel. Companies that are familiar with the negative effects of inflation will be better equipped to deal with these problems as they arise.