Can Your Stocks Benefit from Higher Inflation?

Recently, I went to a supermarket to purchase some groceries and it got me thinking about how expensive everything has become especially after the COVID pandemic.

There is a significant difference in what Rs 500 could buy in 2019 and what it can buy today.

I'm sure you have faced a similar situation while planning your monthly household budgets.

Everyday essentials, from groceries, personal care items, medicines, and education have seen significant price hikes.

Additionally, prices for discretionary items such as cars, movie tickets, restaurant food, and vacations are up anywhere between 50-100% in the past few years.

This inflationary pressure acts as a silent tax, eroding the purchasing power of consumers over time.

As prices rise, the real value of savings diminishes unless investments yield returns that outpace inflation.

Let us say for example, today you can run your house with a monthly budget of Rs 30,000 per month and save 7-8%.

At the current rate of inflation of India at 5.5-6%, your income should grow by at least 6% net of taxes.

If not, you start losing the real value of your savings. The same Rs 30,000 next year will not be sufficient to run your monthly budget.

When prices of commodities increase rapidly, it is unfavourable for margins of most of the companies.

They run operations at lower margins as their cost of raw material goes up significantly.

To safeguard their margins, they increase the prices of their products and services.

However, it is not so easy to pass on the raw material price increase.

Higher prices of products discourage the consumer from spending which in turn leads to lower sales.

There are various reasons for the commodity price increase such as demand supply mismatch, geo-political tensions, wars, erratic climate changes across the globe, lack of transportation, natural calamities, etc.

Have you ever wondered who the real beneficiary of rising commodity prices is?

How can you play it the right way to benefit from rising prices?

There are two types of companies in the market i.e., commodity consumers (autos, fast moving consumer goods, consumer discretionary) and commodity producers (mining, steel manufacturing, tea/coffee/sugar manufacturers).

The commodity consumers face a lot of challenges in the wake of rising commodity prices.

It is difficult for them to achieve a combination of strong sales growth and high margins at the same time.

For commodity producers there is exponential rise in their sales and profitability in-line with the rise in prices of their finished product.

The demand for such basic materials is also not much affected by rising prices as the use of such products is a necessity and not a discretion.

For example, if there is an increase in the price of tea/coffee by 15%, consumption of these products will not go down proportionately.

Similar is the case with the demand of industrial commodities such as steel, copper, aluminium, etc.

These commodities are majorly used in infrastructure projects like making of roads, railways, and buildings.

Such projects are a necessity for the economic growth of the country and employment generation.

Therefore, they are not generally stopped by the government only because of higher commodity prices.

center61849000The chart below depicts the fluctuations in profitability of a commodity producer along with its price (marketcap).

As we can see, profits and price of Tata Steel went up from FY17-18 and again went lower from FY18-20.

As profitability started to improve from FY21 onwards, price of Tata steel went up roughly 4.9X over a period of 2.5 years.

Again, when profitability started dipping from FY22 to FY23, price also corrected.

This is only one example. You can check the profitability and price movement of different commodity producers from 2003 onwards up till 2008.

Stock prices of many commodity producers jumped anywhere between 4-20 times, creating huge wealth for their shareholders.

The reason there are such wild fluctuations in the profitability and pricing of commodity producers is because most of these companies work on remarkably high fixed costs.

In other words, commodity producers' operating cost per unit of sale remains constant.

As prices of their finished products increase, they are able to get better realisations on their sales volumes which directly flows into their profitability because their costs are fixed.

There are reasons to believe that higher commodity prices are here to stay.

• Revival of China’s economy will lead to higher demand for industrial commodities.
• Supply chain shocks on account of the ongoing Russia-Ukraine and the Iran Israel war.
• Natural calamities and erratic weather patterns due to global warming to impact crop produce for soft commodities.
• Demand supply mismatch, etc.

However, please note that investments in commodity producers come with its own set of risks.

They are highly cyclical in nature, and you should know when to take profits around the top of the cycle.

One simple practice which is commonly believed is to invest into them when their PE ratio is at higher end of their median PE band. At that price the profits for the company are quite depressed.

You should exit them at the lower end of median PE multiple as their profits at that point are significantly above normal profits.

Please note you will require further analysis prior to making investment decisions. This approach does not automatically guarantee success.

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure
Equitymaster Agora Research Private Limited (Research Analyst)