How to build an inflation-proof portfolio - The Economic Times Page 1 of 4

Wed, Apr 20, 2011 | Updated 04.05PM IST

11 APR, 2011, 01.37PM IST, RAMKRISHNA KASHELKAR,ET BUREAU

How to build an inflation-proof portfolio

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Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.

- Ronald Reagan, former president of USA

If there is one thing that consumers, investors, companies, and governments fear alike, it is inflation. As it goes out of control, it can become the greatest value
destroyers of all. Inflation is the phenomenon where prices rise and money's worth declines. As inflation soars, long-term investing can end up being a fruitless
exercise. While it is clear that in an inflationary environment, bonds do poorly, the link between inflation and equity returns is not so straightforward.

A number of experts propound investing in equities as a certain way of beating inflation. When inflation rises, equities also rise because a company's revenue or
asset value would go up, along with inflation. However, this theory is only partially true as a lot actually depends on companies' ability to pass on the cost of
inflation to consumers and in ensuring that there is no demand destruction. Historical evidence is mixed with some periods of inflation showing corporate
earnings growth while in others earnings suffered.

While high inflation is not new to India, it is now becoming a more global phenomenon. In India, the Reserve Bank of India has already raised policy rates eight
times in the past 12 months in its efforts to rein in inflation, which continues to stay above the central bank's comfort level. Experts expect the RBI to hike its repo
and reverse repo rates by another 50-75 basis points before inflation can be tackled in the real sense. Looking at commodity prices, particularly crude oil, global
outlook on inflation doesn't appear too benign for the near future.

It is also argued that it is not inflation per se that impacts corporate earnings growth, but tightening of money supply that follows. India has already done it and all
over the world, be it China, Europe, or the US, we see central banks talking of interest rate hikes. Against this background, it makes sense for retail investors to
look for ways to make their portfolios inflation-proof.

ET Intelligence Group presents eight key themes for equity investors that can potentially shield their assets from the deadly fangs of inflation.

1) Extractive Industries

Since high commodity price is a key reason for rising inflation, investing in companies that produce natural resources can be a good idea. Be it oil, minerals and
ores, or farm and forest produce, any extractive industry will have static cost with revenue soaring, along with inflation. Investors can look at oil-producing firms
like Cairn , manganese ore producer MOIL, and Coal India.

MOIL is India's largest producer of manganese accounting for 50% of the total domestic production. It owns 10 mines with 69.7-million tonne ore reserves. It
plans to increase its annual production by about 40% in the next three years from the current 1.1mt. Its business is very closely linked to steel industry, with
about 80% of man- ganese produced globally being consumed by steel manufacturers. Although a PSU, the company doesn't face any pricing restrictions,
which makes it an excellent long term investment.

2) Cheaper Is Better Alternative

Companies that offer cheaper alternatives to costly materials will certainly see their demand growing in times of high inflation. For example, as natural gas is a
cheaper replacement to crude oil, investors can look at companies such as Gail, Guj State Petronet or Indraprastha Gas.

Public sector natural gas transporter Gail (India) is set to benefit from India's increasing gas consumption. The company already controls India's largest gas
pipeline network and despite growing competition will retain 75% market share in years to come. It is doubling its pipeline network within three years. At the
same time, domestic availability of natural gas is expected to go up at a CAGR of 17% between FY09 and FY15. At price-to-earnings ratio of around 15.8, it is
one of the most attractive investments in the gas industry.

3) Look for Recyclers

Recycling generally is a high-cost activity and only high prices can justify recycling. As prices of various natural or virgin materials go up, recycling becomes
lucrative. Even consumers try to use more recycled material in order to bring down overall costs. Thus, rising natural rubber prices are a boon for companies like
Gujarat Reclaim. Ganesh Polytex that recycles PET bottles to make polyester is another example.

Gujarat Reclaim , Asia's largest reclaim rubber producer, benefits from an increase in rubber prices. Reclaimed rubber constitutes around 5% of a tyre. Two-
three years ago, it was just 3%. But is expected to reach 7-8% as natural rubber prices have more than quadrupled since January 2009. In FY10, the company
added 13.3% capacity. Other than the increase in demand for its products, the company also has room to hike its product prices as gap between rubber prices

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How to build an inflation-proof portfolio - The Economic Times Page 2 of 4

and reclaimed rubber widens.

4) Go for Monopolies

Companies which enjoy a monopolistic position or have a very high market share are always in a better position to pass on higher raw material prices to end
consumers. The bigger they are, the higher negotiating power they hold with regard to raw material supplies. Some such firms are Powergrid Corporation and
Power Trading Corporation.

Power Grid enjoys the dominance in power transmission business. It has almost 100% share in interstate transmission and over 50% market share in intrastate
transmission. High capital expenditure required in this business is a big entry barrier in transmission business. It will benefit from increasing power capacity at a
CAGR of 17% in another five years. With current capacity of around 175 gw, already there are transmission bottlenecks. This demand-supply gap ensures that
the company will benefit from the ongoing high capital expenditure.

5) The Royal Protection

For companies like the power major NTPC, the raw material prices are a pass-through since their returns are guaranteed. Such companies may face stagnation
in good times, but in a high inflation phase, they can be good value preservers. Look out for them if they come significantly undervalued. At current valuations,
NHPC can be considered a good candidate.

Being a hydropower generation company, NHPC is insulated from the demand-supply fluctuations of fuel such as coal or gas. Plus, in the scenario of rising fuel
prices and concern over fuel availability, NHPC has an edge over its thermal peers as it can offer power at competitive rates due to its low cost of production.
Also, the power utility companies operate on a fixed return on equity business model, safeguarding the return. The zero raw material cost, high demand for its
product and the fixed return model give NHPC's earnings that extra cover.

6) Bet on Brands

Companies enjoying strong brands and a market leadership will find it easier to negotiate raw material prices and pass on hikes to consumers. Companies such
as Asian Paints , Pidilite and Castrol have done consistently well even in turbulent times.

India's leading lubricant maker Castrol has an advertising budget matching any FMCG company and brand ambassadors ranging from Sachin Tendulkar to
Brett Lee. This has enabled it to overcome its natural disadvantage of being a non-integrated player compared with its competitors, oil marketing companies that
enjoy a cost advantage, thanks to their refineries and the distribution network. It has consistently improved its operating profit margin from around 12.5% in 2006
to 26.7% in 2010 despite volatility in oil prices. The margins will remain safe even if oil prices rise further.

7) Highly Innovative Companies

A company with new products or adopting path-breaking new approach to business can battle the cost pressures effectively. Global majors such as Google ,
and Apple would figure under this category. However, Indian innovators having a similar wide scale impact are limited. A recent survey of world's 50 most
innovative companies by Fast Company magazine has just one Indian entry, shaadi.com.

India's largest telecom operator Bharti Airtel thrived in commoditised markets by innovating. It was the first to outsource the management of its networks and
information systems. This helped it fully focus on market penetration. Today, Bharti commands nearly one-third of the total revenue in the country's telecom
sector, much higher than a decade ago. The company was also the first domestic telco to acquire telecom businesses overseas. As a result of its inorganic
strategy, the company now enjoys access to markets in Bangladesh, Sri Lanka, and 15 African nations. The overseas drive is expected to reduce Bharti's
dependence on fast maturing Indian market.

8) Farmer Is King

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With rising food prices globally, a company involved in agriculture will be a natural candidate for investment, which is not possible in India. An indirect way of
playing the agri boom is to look at suppliers of seeds, pesticides, fertilisers and irrigation players. This includes companies such as Rallis India , Tata Chemicals
and Jain Irrigation attractive.

The Maharashtra-based Jain Irrigation holds a leading 50% market share in India's micro-irrigation industry, besides making PVC pipes and sheets. The
government's impetus for micro-irrigation offering a 50% capital subsidy has driven the company's growth substantially. The firm plans to float an NBFC, which
can help facilitate financing farmers installing micro-irrigation systems and will go a long way in lowering its debt burden. Its current price-to-earnings ratio at 22.7
is substantially below its average for last five years.

Present and future options

To face the inflation woes, the intuitive reaction is always to invest in gold, which has become very easy now, thanks to gold ETFs. Silver ETFs, which are yet to
be launched in domestic markets, could also be an extra option for the future. However, investments in precious metals are criticised as being unproductive and
sufficient barely to compensate inflation. While a part of one's portfolio can surely be invested in gold, physical or ETF, relying solely on it to beat inflation is
inadvisable.

Mutual fund schemes designed to invest specifically in commodity companies could also be a good option to best the inflation. However, there aren't many such
Indian companies and the only alternatives available are a handful of MF schemes that invest in global markets, either directly or through foreign funds (fund-of-
fund) route. The performance of these funds has been superior of late, in spite of their lack of popularity. Investors can take exposure, but only after considering
the currency risks involved.

Best to avoid

It is not what you bought, but what you didn't buy that decides returns on your investments in turbulent times. Hence, one needs to beware of industries more
susceptible to high inflation. Interest rate-sensitive industries such as banks and NBFCs, real estate and auto top the list. EPC contractors with lumpsum
contracts also see their margins squeezed as commodity prices go up. Companies that don't have pricing freedom such as IOC , BPCL , HPCL are best
avoided. Industries depending on discretionary spending such as aviation and hospitality also won't be favourites if inflation is high. Companies with low value-
added products such as most chemical players will also face some margin pressure.

Conclusion

The above themes can serve as a set of guidelines for investors to select companies for their equities portfolio that have the potential to fare well even in times
of high inflation. For some companies, more than one theme applies, making them more compelling for investment. Investors will, however, need to check
valuations before taking an investment call.

With inputs from Bakul Chugan, Crystal Barretto, Jwalit Vyas and Ranjit Shinde

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