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How Does Inflation Impact Top Growth Stocks?

Inflation data for the month of December is in, and although it was previously described as transitory, it’s showing no signs of slowing down.

Inflation has hit a high it hasn’t seen in more than 40 years as of December 2021. In the most recent consumer price index (CPI) data published, inflation hit the 7% mark, which begs the question, will this moderate, or could it last for years?

Why does inflation matter for growth stock investors?

Inflation historically has treated certain industries better than others. Technology, for example, is an industry that hasn’t lived up to expectations in the past. There’s a couple of reasons for this.

Companies can lose pricing power. Increased operational costs, labor costs, and general expenses tend to rise and it can be difficult for some businesses to raise prices in line with this and maintain profit margins. This realization can see valuations and price-to-earnings (P/E) ratios come crashing back down to reality.

Taking the software-as-a-service (SaaS) category as an example, profit margins are of the utmost importance for both enterprise growth and attracting investors. If the company struggles to increase prices in line with inflation or stands to lose customers as a result of price increases, this will directly impact the company’s returns and future prospects.

This stacks up well for value stocks because it makes a predicament for investors. If value and traditional investments are going to perform better for the foreseeable future, why would you invest your money anywhere else? Value stocks often are better capitalized, provide more essential services, and as a result are able to pass on any inflationary costs to customers without impacting their business in a major way.

In some cases, they’ll even perform better. With interest rate hikes looking inevitable at this stage to combat inflation, banks and the financial sector, in general, could see a healthy boost in profitability derived from credit services and lending products. So, all-in-all, we tend to see capital plucked from growth and into value, dropping prices further with the rotational change.

Takeaway

While growth stocks are taking a hit at the moment, it doesn’t mean their time is up. We’ve seen before the market works in cycles that favor specific industries at different times. Value outperformed growth in the decade after the dot com bubble, growth outperformed in the last decade.

What it shouldn’t do is affect your overall investment thesis. If you’re holding solid companies for 5-10 years, this will likely be a blip in the market in the grand scheme of things. During uncertain circumstances, diversification can be an investor’s best friend. Holding companies in your portfolio across growth and value, as well as geographies and industries, can be the best way to optimize both potential gains and offset any potentially major losses.

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