Even Brookfield Asset Management (BAM 0.39%) has not escaped poor investor sentiment in this current bear market. As a result, Brookfield's stock is now down close to 30% from its all-time closing high. Most people believe the cause of the current market downturn is the largest rise in inflation in 30 years.
However, here's one key reason inflation will help Brookfield outperform.
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Inflation improves the value of real assets
Brookfield CEO Bruce Flatt has often said that real asset businesses are the best places to invest in a high-inflation environment. For the unaware, real assets refer to physical or tangible assets -- a few examples are natural resources, real estate, commodities, and infrastructure like electrical transmission lines.
Flatt is bullish on real assets for good reason.
Many studies have examined real asset performance in both inflationary and noninflationary environments. For instance, a Bloomberg study done between 2003 and 2020 showed that in periods of greater-than-expected inflation, diversified tangible assets, infrastructure, energy infrastructure, and natural resource equities all had better-than-average annual returns over equities or fixed income. Additionally, real assets perform relatively well in less-than-expected inflation environments, too. Consequently, most Brookfield holdings consist of real asset investments, and many people consider it the most extensive portfolio of inflation-protected businesses worldwide.
Most of Brookfield's portfolio requires significant funding upfront, earns very high margins, and has lower expenses than its capital cost. Consequently, in an inflationary environment, expenses for Brookfield's real asset businesses will grow at a fraction of the pace of revenue growth -- resulting in rising margins and increased value for the investments. And Brookfield's rising net income is a sign that the gains from inflation are already showing up.
Data by YCharts.
The above chart shows both the negative impact on Brookfield's net income from the COVID-19-induced economic slowdown and the rebound in net income after the economy started recovering and people began noticing rising inflation.
The best part is that by the end of 2020, the company had already anticipated that in 2021, inflation would soar higher than many analysts had forecast, and so it loaded up on many real asset businesses, primarily in real estate and infrastructure. So Brookfield investors can expect even higher future returns if inflation persists.
The danger in interest rates rising too high
Runaway interest rates are one of Brookfield's most significant risks, as the company depends heavily on debt to run its business. And rising interest rates can significantly hurt companies that have high debt.
Brookfield's first-quarter 2022 earnings release shows the company has only $11.82 billion in cash and equivalents against $185.03 billion in debt. The stock could drop significantly from current prices if multiple loans default based on out-of-control interest rates.
Data by YCharts.
What helps save Brookfield's bacon is that $173.09 billion of Brookfield's debt is nonrecourse -- meaning that when one of Brookfield's operating companies secures a loan, it's the subordinate operating company that is on the hook for the loan. In addition, the lender has no recourse for collecting additional money from the parent, Brookfield, should the loan turn sour. So while the non-recourse loans might appear on Brookfield's balance sheet, it has no responsibility to repay them -- protecting the parent company.
Additionally, even if interest rates should rise more than expected, Flatt said in the first-quarter earnings call that even 5% interest rates are low by historical standards for Brookfield's cash-generative businesses and can be absorbed in the company's margins. It is also unlikely that interest rates will even rise to the 5% level in the short-term, as many experts expect a third-quarter recession. Normally, the Federal Reserve will stop raising interest rates in recessions.
Brookfield is a great buy at today's price
Although Brookfield expects to significantly benefit from the effects of inflation for the next 24 months, the market values the company with a PEG ratio of just 0.9 -- far below the 3.1 ratio achieved in March 2021. Additionally, a PEG ratio of below 1.0 suggests an undervalued stock.
Suppose you are looking for a company selling at a cheap valuation that can still outperform the market over the next several years. In that case, few companies are better to consider investing in than Brookfield Asset Management.
