Curmi & Partners

Portfolio Tweaking In An Inflationary Environment

By Noelle Micallef

The constant increase in inflation continues to squeeze consumer budgets more so than in the past 40 years. However, now may be the best time to put long-term savings in the stock market, as historically, it has been shown that investing in equities (stocks) is generally a good way to outrun inflation. In general, the average annual return of the S&P 500 index is about 10%, which is higher than then 8.3% annual inflation rate seen in April 2022 in the United States.

Investors purchase these shares with the expectation that a company will grow and generate returns in the form of capital gains, and/ or dividend generation. Apart from this income, investing in equities has other advantages. When buying shares, the shareholder becomes a part-owner of the business. Unlike bonds, shares carry voting rights and therefore shareholders may exercise some sort of control over the company. Also, shareholders have limited liability, which means that if the company goes bankrupt, the maximum that a shareholder may lose is his total investment made in the shares. Existing shareholders are also normally given first preference for rights issues (shares issued at a lower price than the current market price) and bonus issues (free shares given to shareholders instead of dividends).

On the other hand, stocks are riskier than many other asset classes because money is invested based on the belief that a company will do better in the future. There is no collateral security protecting the investment and typically there are no guaranteed dividends. Furthermore, the price of a stock is based on several fluctuating factors which are sometimes out of the company’s control such as industry-specific news and changes in market trends and consumer appetites. Although a shareholder has voting rights in a company, smaller investors who invest in larger institutions have less of an impact on corporate decisions. Finally, in cases where companies go bankrupt, shareholders are the last to receive any sort of repayment for their investment, after all other costs, debtors and other stakeholders are repaid.

There is a large variety of names to choose from, thereby providing investors with diversification opportunities. Equities are normally classified as either growth stocks or value stocks. The former relates to those companies which are considered to have future potential; hence an investor may deem that the current price is relatively cheap as compared to what the company will be valued in the future. Alternatively, value stocks are usually larger, more established companies which analysts believe are undervalued on the market. In times of inflation, interest rates are usually increased to combat rising prices. A way of valuing stocks is to discount future expected cashflows using a discount rate, which in turn would be driven by prevailing interest rates. All else being equal, a higher inflation rate implies that the value of future income would be worth less in present value. Therefore growth stocks, which generally expect a higher volume of cash flows in the future as compared to value stocks, are proportionately more negatively impacted than value stocks in times of inflation.

The MSE has seen an increase in new equity listings over recent years with a record of over €221 million being listed in 2021. The first few months of this year have also been quite busy, with AX Real Estate plc and M&Z plc listing a total of nearly €90 million worth of shares, and APS Bank plc announcing that it is planning to implement an Initial Public Offering. It should be noted, however, that local investors tend to hold equity investments for the long-term and are generally interested in companies which pay regular dividends. This limits liquidity on the local market. Having said this, the increase in companies listing locally in recent years, and a generally more open approach towards equity investments may indicate signs that the equity market may become more active in the foreseeable future.

Whilst investing in equities is important in inflationary periods, investors should continue to protect their portfolios via diversification and rebalancing, for instance having investments spread across stocks, bonds and more. Furthermore, within each asset class it is important to hold a variety of industries and sectors. Finding the right balance is essential to make profits on long-term investments.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.