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Deflation And Stocks

I just read some research notes saying that deflation is hitting Singapore too. After Japan and Europe. So what sort of stocks would do well in a deflationary environment?

Before we explore my answer though, let's examine why deflation is generally thought to be bad for stocks. Also, note that it's just "my answer", not THE answer.

Generally, deflation would be bad for stock prices through various mechanisms.

First, I use deflation in the definition of a symptom i.e. falling prices instead of the correction definition of simply less money since the former is likely to be the more common interpretation. With deflation, a company is suddenly selling less dollars worth of its goods or services. Its revenues and profits are shrinking. Its assets are also worth less dollars now since prices are generally falling and replacements are selling for less. Regardless of whether we value the stock of the company by asset or by earnings, the stock is now worth less than when in an inflationary environment.

There's also the discounted cash flow method of valuing stocks. Analysts and investors generally put in a growth forecast when pricing stocks. Inflation is one of the growth components. The assumption here being that the price of processed goods and services would outpace the price of raw materials and wages. Take away the inflation assumption and suddenly a company would be projected to be earning less in the future. This leads to a lower present value of discounted future cash flows and hence a lower stock price.

In other words, the stocks that did well with inflation are likely to do badly with deflation, with exceptions of course. For example, companies with inelastic demands and pricing power may do better since they can still retain prices while paying less for raw materials, people and machines. That's why Warren Buffett calls them moats--they really protect the castle.

Moats aside. With goods, people and machines worth less dollars, deflation means that money is worth more now. So stocks of companies hoarding a lot of cash should do well in a deflationary environment since the value of the cash hoard is now growing.

Here's another answer which should have come by common sense. Companies with none of their assets or operations in a deflationary environment. A stock may be listed in Singapore (or Japan, or Europe, or the US, or anywhere else) but the underlying business may just be based elsewhere, hopefully where there's some good inflation.

Just some food for thought.