Inflation and interest rates have captivated investors’ attention for nearly a year. After being little more than an afterthought for much of the past decade, the flames of inflation were fanned by a torrent of stimulus designed to prevent a full-scale economic collapse in the face of a once-in-a-century pandemic. The economic collapse never came (in large part, due to the stimulus itself), and instead the economy roared back to life.

For a time, this seemed like the best of both worlds for investors, as strong demand produced record revenue and earnings, and low interest rates pushed up valuations, causing equities to climb ever higher. Despite a marked improvement in the economy, the U.S. Federal Reserve kept interest rates low, and the Treasury Department continued to spend trillions of dollars on fiscal stimulus.

Now, investors are dealing with the aftermath of fiscal and monetary policy that stayed much looser for much longer than warranted. The result is raging inflation that must be reined in with rapid interest rate hikes. The impact on markets is twofold. Higher interest rates reduce the present value of cash flows, thereby reducing equity prices. This seemed to be investors’ focus for much of the first half of 2022. That focus seems to have now shifted towards the economic impacts of inflation.

The First Punch

Why are investors so worried about inflation? Simply, because it’s bad for the bottom line. Most obviously, it increases the cost of doing business, and reduces margins to the extent that businesses can’t push through price increases.

It can also destroy demand and reduce revenue to the extent that customers are forced to pare back on, or choose between, purchases. Demand has so far been less of an issue given that employment and wage growth have remained strong. As a result, investor attention appears focused mostly on margins.

This is the obvious punch—the one that investors can see coming from a mile away—and the one on which investor attention is currently trained. Indeed, maintaining margins is thought to demonstrate that a business can pass on cost inflation through price increases, and is therefore successfully navigating the current macro environment.

Yet it’s inflation’s second punch that can deliver a blow that investors may not be expecting.

The Second Punch

A bout of inflation can have lingering effects on financial statements, even after the real economy impact has passed. That is, the effects of inflation take time to work their way through some components of the financial statements. This happens through two primary transmission mechanisms: Capital Expenditures (CapEx) and Inventory.

While most income statement line items reflect cost inflation in real time because they represent costs incurred in the current period, two items stand out for operating slightly differently: Depreciation and Cost of Goods Sold (COGS)

CapEx and Depreciation

As a lot of investors will know, the depreciation expense recorded on the income statement is based on historical costs. Over the past decade, with inflation subdued and trending lower, the difference between depreciation expense (historical cost of the asset, spread over its useful life) and maintenance CapEx (the current cost required to maintain/replace the asset) may have been minimal. As inflation increases, the gap between these two figures grows.

In an inflationary environment then, depreciation understates maintenance capital requirements, and therefore operating margins are not adequate to assess whether a business is keeping pace with inflation. To judge whether a business is maintaining its real earning power, investors should adjust the depreciation charge to reflect the current replacement costs of a business’ assets.

One obvious place to look for clues on the replacement cost of assets is the CapEx line in the Statement of Cash Flows, which will reflect current expenditures on property, plant, and equipment. In an inflationary environment, CapEx will increase in advance of depreciation, which may result in unexpectedly weak cash flows, especially if investors are looking to operating margins as an indication of a company’s ability to weather inflation.

One note of caution is in order: a business that has managed to avoid an increase in CapEx may at first seem like it’s navigating an inflationary environment particularly well, but investors simply can’t take these figures at face value. Businesses may cut back on certain expenses in times of stress, but this often harms their competitive position or growth prospects, especially if competitors press on with spending. This is especially true of investments in long-term productive capacity such as property, plant, and equipment. As a result, it’s imperative to compare spending across the whole industry, to determine whether a company is underinvesting and damaging its long-term prospects.

Inventory and COGS

As with depreciation, the Cost of Goods Sold (COGS) recorded on the income statement is also based on historical costs. With this line item there is an additional nuance—the chosen inventory valuation method. The three most common inventory valuation methodologies are last-in-first-out (LIFO), first-in-first-out (FIFO), and average cost.

Each of these inventory methodologies will result in a different COGS and will vary in how quickly they reflect the impact of inflation. COGS will be closest to the current replacement costs of inventory when a company is using the LIFO method of accounting, as the most recently purchased inventory items (last in) are expensed first (first out).

At the opposite end of the spectrum, the FIFO method of valuing inventories will understate the replacement cost of inventory. This is true even if the business has high inventory turnover because there is always some lag between the costs paid and when those higher costs flow through COGS. As with depreciation, this will be reflected first on the balance sheet as higher inventories and on the statements of cash flows as a cash outflow to support inventory builds, crimping cash flows. It later flows through the income statement through COGS.

This lagging effect of inflation on COGS was recently on display in one of our portfolio holding’s forward guidance for 2023. In its Q3 FY 2022 earnings release, Johnson & Johnson mentioned that although investors should expect abatement of inflationary pressures, 2023 results will be negatively impacted by the higher costs of inventory manufactured during 2022. This business uses FIFO to value its inventories, which as mentioned, results in the greatest lag between rising inventory costs and rising COGS.

Dodging Punches

Given that there is a lag between real-world inflation and when it appears in financial statements, businesses that merely hold operating margins constant are unlikely to be maintaining their earning power.

To hold earning power constant, either 1) current period operating margins must rise to account for the higher costs of replacing both inventory and property, plant, and equipment, or 2) businesses will need to continue to raise prices even after real-world inflation has dissipated to maintain operating margins once inflation flows through the income statement.

Investors should pay close attention to businesses with high capital intensity and high net working capital requirements. These businesses may appear like they are keeping up with inflation, but in the years that follow, may surprise investors with weak cash flows and margin compression.