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NEW DELHI: Valuation guru Aswath Damodaran says if an investor wants to invest in a company that could operate as an inflation hedge, s/he should try identifying one with strong pricing power, low input costs and the one that belongs to a business where investments are short-term and reversible.

On the risk front, one may also like the company to have a large and stable earnings stream and a light debt load, he said in a blogpost on May 20.

In 2022, the collective market capitalisation of all US firms dropped by 19.75 per cent, with the bulk of the drop occurring after April 1, 2022. During the period, the three worst performing sectors were technology, consumer discretionary and communication services, and the best performing sectors were energy and utilities, old standbys for investors during tumultuous periods, Damodaran noted.

The value investor compared trends of the 1970s with that of 2022 and said investors will undoubtedly find vindication for their beliefs that the correction in stocks in the US was long overdue and that it has been a return to normalcy where safe stocks in boring sectors that pay high dividends deliver excess returns.

“I do think that given how consistently growth stocks have been beating value stocks for the last decade, a correction was in order, but I believe it is way too early to proclaim the return of old fashioned value investing,” he said.

Damodaran said companies that generate more cash flows from their operations and return more of that cash flow in dividends to stockholders have clearly held their value better than companies with low or negative cash flows that pay no dividends, in 2022.

He said that outperformance of small cap and low price to book ratios that one saw in the 1970s is also being replicated in 2022.

“As in the 1970s, the small cap premium seems to have returned with a vengeance, as small cap stocks have outperformed large caps in 2022, and the lowest price to book stocks have done less badly than high price to book stocks,” he said.

Damodaran said unexpected inflation seems to have a large impact on the behavior of small cap stocks, with small caps outperforming in decades where inflation was higher than expected and underperforming in decades with lower than expected inflation.

The effects of inflation on firm value boil down to the impact inflation has on expected cash flows and risk, he said.

“The impact of inflation on individual company values can vary widely, with a few companies benefiting, some affected only lightly, and other companies being affected more adversely, by higher than expected inflation,” Damodaran said.

To summarise, Damodaran said if one believes that there are more surprises to come on the inflation front and that a recession is not only imminent, but likely to be steep, the returns in the first five months of 2022 will be a precursor to more of the same, for the rest of the year.

If one believes that the market has mostly or fully adjusted to higher inflation, betting on a continuation of the small cap and value outperformance to continue, is dangerous, he said.

“To the extent that there may be other countries where inflation is not the clear and present danger that it is in the United States, investing in equities in those countries will offer better risk and return tradeoffs,” Damodaran said.


(Disclaimer: Recommendations, suggestions, views, and opinions given by the experts are their own. These do not represent the views of Economic Times)

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