Broiling in inflation

SMARTSHARE

If you put a frog in a pot of boiling water, it will jump straight out. But if you put the same frog in lukewarm water and gradually increase the temperature, there's a good chance that the amphibian will passively swim around until it's broiled.

This is a parable about inflation. It's literally true because frogs are stupid. But human beings are similarly stupid about recognising inflation. They don't jump out of the pot if prices rise gradually.

India is due for its next bout of inflation over the next couple of years. Some of the classic ingredients are in place. Basic commodity prices, especially crude oil prices, are high. There's asset inflation "" stocks and real estate have shot up. This is encouraging high consumption and thus, creating higher prices all round. Money supply is growing much quicker (20 per cent) than the RBI target (15 per cent).

But it's likely that the inflation rate will rise gradually over the next couple of years rather than jump. There is not much the common man can do. Unless he can emigrate or create export earnings, he can't "jump out of the pot". He has to try to pick assets that will retain their value during the upwards spiral.

One obvious haven is precious metals, which hold value during inflationary runs. But they don't earn income. An obviously avoidable asset is long-term fixed debt, which rapidly erodes in value. Between these two extremes, it's a toss-up what returns a given asset will land during an inflationary phase.

India is under-indexed; dearness allowances are linked to consumer price indices, which were last rebased ages ago. It's also a continent-sized economy; inflation does not run at the same rates in Delhi, Port Blair and Imphal.

Bad indexation may have one good effect. In Brazil and Israel, hyper-inflation was fuelled by dearness allowances that closely reflected actual inflation. Every upward spiral meant more money sloshed into the system through indexation. In India, inflation may take its toll of individuals but it won't cause automatic increases in money supply.

The CPI is due to be amalgamated and rebased. The new CPI would ideally reflect average inflation better than the old split CPI series. Given that it's a politically sensitive exercise, the Left will probably hold it up on general principle. For once, they may actually be doing the nation a favour.

Stocks rank somewhere between debt and precious metals during inflationary periods. Stock prices fall when interest rates rise "" that is relatively straightforward. But individual businesses may boost earnings sufficiently quickly to stay ahead of inflation. Thus inflation can create room for value investors to build cheap portfolios.

If you hold stocks, you have to be prepared to average down during inflationary periods. Concentrating on export-oriented businesses is a good idea "" it lets you pull one leg out of the hot-pot at the least.The other option is to find businesses that possess pricing leverage, so inflation can be passed on to customers.

This one's very tough. In certain key industries (specifically petro-products and the power sector), controls prevent price hikes. In others, such as aviation or telecom, competition prevents hikes.

One possible candidate is hotels """" occupancy rates are running at near 100 per cent, there are no price controls as such and there are significant forex-denominated earnings. Most hotel stocks are dividend-payers though the entire sector is high-priced. You could buy and average down.