In this final chapter of the book, Dreman explores whether high inflation is bad for equity investments.
The well understood type of inflation is when too much money is chasing too few goods. However, Dreman presents other factors that have recently been sources of inflation including 1) higher commodity prices being transferred in from overseas, 2) the sociopolitical belief that real income needs to increase for working people and labor forces able to enact this belief and 3) anticipatory product pricing used by businessman to maintain profit margins. Dreman observes that a rise in one of these forces causes a corresponding rise in the other two forces.
Dreman suggests that businessmen normally establish prices by projecting costs of labour, material and other costs in order to maintain profit margins. He observes that profit margins in companies has remained very stable regardless of whether inflation was 2% or 10% over recent years. Dreman shows data between 1952 and 1981 split up into 3 distinct time periods (1952-1961, 1962-1971 and 1972-1981), that demonstrate average profit margins of 14.8%, 15.5% and 14.9% for S&P 400 Industrials during those time intervals. Dreman observes that during the ten years ending 1981, a period of accelerating inflation, corporate earnings were robust despite the rise in prices. Dreman also shows evidence that dividends of the S&P 400 between 1971 - 1981, have increased almost as fast as the rise in prices. In addition, a paper by Modigliani and Cohn, has produced evidence against the widely accepted belief that corporate profits decline sharply during periods of high inflation.
To sum up, Dreman finds the belief that corporations can't pass on inflationary costs to consumers and that earnings and dividends are stymied during inflationary periods not well supported. He asks the question, "why then have returns on stock investments done poorly during high inflationary periods"?
Modigliani and Cohn attribute the poor performance of stocks in inflationary periods to institutions not understanding the effect of inflation on corporate profits. In fact, they claim that institutions place too low a valuation on stock earnings relative to interest rates and high-grade bonds during inflationary periods. The problem is that institutions use bond interest at nominal rates in determining the acceptable earnings yield for stocks, thereby systematically requiring returns that are too high from stocks during inflationary periods.
According to Modigliani and Cohn, another problem with stock valuations during high inflationary periods is that certain accounting adjustments are made such as reducing swollen profits from inventories and increasing the impact of future depreciation expense but there is failure to account for the fact that a company's debt is actually decreasing in real terms.
This concludes my review of The New Contrarian Investment Strategy. I have found the book to be exceptionally informative and relevant despite being published in the early 1980's! I am sure I will be referencing this book in years to come and it is a most welcome addition to my investment book library.