Inflation and the Value Rotation — Are They Here to Stay?

A brief discussion about today's economic and market environment with Diamond Hill portfolio managers Chuck Bath, Austin Hawley and Chris Welch.

How does higher inflation impact equity investors?

Chuck Bath: The secular outlook for inflation is just one of the many factors that impact an investment decision. We think about the effect of higher inflation the same way we consider all factors—on a case-by-case, bottom-up basis. We know some businesses do well in an inflationary environment, while others are hampered. Inflation coupled with the ongoing economic recovery has created some interesting areas of opportunity in the market for bottom-up stock pickers like Diamond Hill. Take copper for example. Supply and demand are tight even though we are only in the beginning stages of a recovery in the U.S., and the current supply-demand balance doesn't account for recoveries abroad, some of which are trailing the U.S. On top of a cyclical recovery, we see strong secular demand for copper due to the increasing adoption of electric vehicles along with other environmentally friendly energy investments. In our view, copper demand should remain robust for a long time, and copper companies are generating significant free cash flow as the commodity price rises. Equally important, it will require significant time and investment before meaningful supply can be brought to the market. As such, we've started looking at companies whose stock prices don't necessarily reflect that secular opportunity.

The other area related to inflation that investors should keep an eye on is the labor market. We're already facing a labor shortage here in the U.S., which means businesses are going to have to pay more to get people back to work. If that happens on a large enough scale, inflation could become more secular in nature, rather than a shorter-term cyclical event.

Can you comment on the recent outperformance of value stocks and your outlook going forward?

Austin Hawley: We have gone through an extended period of relative advantage for growth stocks and growth investing—really since the global financial crisis. The question for investors today is whether we are seeing a secular shift and not just a one- or two-quarter occurrence.

As we think about the last decade, growth has been scarce. Companies that have experienced growth and have been able to protect it have been highly valued in the market. On the other end of the spectrum are companies that have had to fight hard to stay alive via productivity gains, cost cutting, merging with other businesses, or even going out of business. Looking out over the next 10 years, if we move into a nominal growth environment, a lot of those relative advantages should reverse. We could be in an environment where you have leaner companies and more consolidated industries that have operating leverage and can produce significant growth—not just over a quarter or two, but over an extended period of years.

Thus far, we've had a short time period with a pretty significant move upward in value stocks. We're not in the business of making short-term market calls—nor does our process require it. However, there is potential for this to be a real secular shift where some of these companies can perform well for years in terms of fundamentals. The one caveat being an overheated economy and rising inflation. As we think about the portfolios we manage, the fundamentals of some of the more traditional value stocks that have been left behind for the past decade could really support attractive returns going forward. On the other hand, our goal is to position the portfolios to do well regardless of the macro environment. As Chuck mentioned, we are looking at businesses that would also do well in an inflationary environment and want to make sure the portfolio is positioned well for the long term regardless of the direction of the economy.

What is one of the biggest risks as you think about the macro environment going forward?

Chris Welch: As bottom-up stock pickers, one of the biggest risks is whether a company's revenues and margins will drop significantly in an economic slowdown. If you're invested in a lot of cyclical companies, that risk can happen all at once across a broad range of industries, as we saw during the financial crisis. Looking forward, one of the biggest risks we face are companies that are unable to accelerate their revenue growth and profits in a high growth economy—or an inflationary environment. Managing portfolio risk then becomes about whether or not you're invested in companies that can benefit by improving their fundamentals if the economy is running hot for an extended period. Often those companies are more cyclical, and historically we've owned fewer cyclical companies in our portfolios to manage that risk. In today's environment, managing risk might mean having more cyclical companies in the portfolio. All that said, there is still a risk that we have an economic slowdown and cyclical companies see a sharp drop in revenue and profits.

Our job as portfolio managers is to make sure our portfolios are well-diversified and comprised of companies that we believe can increase the value of the business over the long run—regardless of macro influences.