Why Equities are actually the best Hedge against Inflation

Do you really know why Equities are actually the best Hedge against Inflation?

Suppose we take the following case. Say Steel is available at Rs 1 lac per ton. A Maruti Car needs half a ton or Rs 50000 worth of Steel. Let us assume that the cost of the car is 2 lakhs and that price of the car is directly proportional to the price of steel. Further, the profit margin on each car is assumed to be 20000.

Suppose the price of steel increases by 10% - to 55000 per ton. Steel input cost will be 55000 per car. Price of the car will increase to 2.2 lakhs, because Maruti Udyog would pass on the material cost increase to the customer. The margin on each car will go up from 20000 to 22000.

Thus, the inflation of 10% does not affect the share price of Maruti, because the margins or profitability also has gone up by 10%. In other words, Earnings have kept pace with inflation. And it is just a matter of time before price rises to match the increase in Earnings. The car became expensive due to material cost increase, but the company’s profit margin did not come down.

That’s the beauty of Equities!

What about gold? Gold has generally kept pace with inflation, but not significantly beaten inflation. In 1980, price of gold was Rs 2000 per 10 gm. Eggs then were priced at Rs 3 per dozen. While gold has gone to 30000 in 2013, eggs have gone up to Rs 48-60 per dozen. Bananas were at Rs3 /dozen in 1980 as against Rs 40-45/dozen today. Bread was available at Rs 1 per loaf, today it is Rs 20 per loaf.

So, while Gold has kept pace with Bananas, Eggs and Bread have moved up faster than gold. Diesel prices which were Rs 1.20 per litre in 1980, are Rs 60 per litre today! Only if one could have invested in Diesel instead of Gold!! But while Diesel price has gone up 50 times, Sensex has gone up 200 times !! So, whether diesel or bread or eggs, Equities have all bases covered!