Big picture factors, such as forecasts on the direction of interest rates or the strength of the U.S. dollar are not factored into their analysis. The story begins and ends with the company. I used to be a dyed-in-the–wool bottom-up investor, but the 2008 global meltdown of the financial markets changed my thinking.
While I don’t try to predict or forecast economic events, I am now more cognizant of the economic backdrop than I was prior to 2008. After researching a company’s financial statements, competitive advantage, management and valuation, I try to account for economic headwinds that could derail the company.
For example, although payroll companies such as ADP (ADP) and Paychex (PAYX)were financially sound and trading for attractive prices, I didn’t recommend them in the early part of 2008. My big picture view, which didn’t take a great leap of faith, was that unemployment would continue to rise and interest rates would stay the same or move lower.
My logic was simple: With fewer people working, payroll companies would see a drop in revenue. Since there is a lag between the time a business wires their payroll to ADP and the time an employee cashes his or her check, companies like ADP earn interest on funds held for clients. In 2007, ADP earned $635 million on funds held for clients when the Fed funds rate was 4.5%, and dropped to $542 million in 2010 as the Fed funds fell to 0.75%.
During the height of the financial crisis in November 2008, the Federal Reserve began implementing a monetary policy of quantitative easing (QE). QE is a policy where a central bank, like the Fed, buys government bonds and other financial assets with new money that the bank creates electronically, in order to increase money supply and the excess reserves of the banking system.
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The Fed began buying mortgage-backed securities (MBS) in November 2008 and by June 2010, held $1.2 trillion of bank debt, MBS, and Treasury notes. Their action was vital for stabilizing the financial markets and preventing the economy from further meltdown.
In August 2010, the Fed saw that the economy was not growing as quickly as it would’ve liked, so they implemented another round of easing, or QE2. Many investors and economists felt that this second round of easing was unproductive and would not help create jobs or economic growth. Instead, QE2 would push stock prices higher and fuel a rise in commodity prices, unleashing price inflation. And that’s pretty much how it played out.
According to Fed Chief Ben Bernanke – and the U.S. Department of Labor – inflation is not a problem. The Labor Department tells us that for the 12-month period that ended in March 2011, consumer prices increased only 2.7%. Does that sound right to you? Take a look at real world prices: Most have risen much more than 2.7%.
Inflation is a killer of currencies. The impact of inflation over long periods of time is ruthless as it eats away at the purchasing power of the dollar. Year after year, the amount your dollar buys becomes less and less.
One dollar in 1940 would have the purchasing power of only 7 cents in 2010 … a depreciation of 93% of its value. One dollar in 1990 already lost 41% of its purchasing power by 2010.
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I’m afraid that given the current economic environment, inflation will get worse over the next several years. Now is the time to make the right decision and invest your dollars in an asset that can keep up with and possibly outperform inflation. Because if you don’t, you’ll still end up with dollars but they won’t be able to buy you much.
The answer is not gold
The knee jerk reaction that most investors have when they hear about inflation is to run to gold. But gold is not really the best inflation hedge you can find. In addition to the high commission and wide bid/ask spread when buying gold, you also have the problem and cost of storing it.
Other than being nice to look at, gold doesn’t offer much more than that to the investor. It doesn’t pay dividends or generate cash flow, and its value is based on what someone else is willing to pay for it. Warren Buffett calculated that all the gold ever mined in the world would create a cube 67 feet on all sides and would have a market value of about $8 trillion.
If you had the choice of owning an $8 trillion cube of gold or owning all the farmland in the United States, and 10 companies the size of ExxonMobil (XOM), and have $1 trillion left over, which do you think would be worth more in the next 10 years?
Owning pieces of businesses (stocks) is an excellent way to outperform inflation and grow your money. During periods of inflation it’s not enough to buy businesses that are consistent and predictable, have top-notch management, and an enduring competitive advantage. Buffett recommends that you need to find businesses that:
1. Provide goods or services that are always in demand.
2. Are able to increase prices with inflation.
3. Require little capital investment.
This month’s Prime Time selection hits the mark on all counts. Over the next several months I’ll be selecting businesses that are able to thrive during inflationary periods.