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Inflation and Stock Selection

October 05, 2013 | About:

graemew

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It's been so long that inflation has been largely under control in Western economies that many investors and analysts have not directly experienced its impact on everyday life. As I visit my local grocery store and throw my favorite shopping items into the basket, I tend not to check the current prices; I've become accustomed to fairly steady, slowly upward prices for a long time now.

Apart from a sudden pick-up in certain agricultural commodity prices around 2007, milk being one example that comes to mind, my time spent at the local supermarket has been largely predictable and uneventful for many years.

But as the third round of the Fed's easing policy continues for a while longer, economists and analysts foresee rising inflation as one of the primary risks from what has been described by Pimco's Mohamed El-Erian as ''an unprecedented high-stakes experiment'.' And the printing press has been working overtime not only in the U.S., but also of course in the UK, Europe and Japan as well.

No doubt focusing simply on the contents of my weekly shopping basket is only one way of measuring inflation, and some economists argue that inflation is here right now as evidenced by rapidly rising stock, property and oil prices. Is it now too late to plan for more inflation?

One of the best recent analyses of inflation and inflation hedging is the two-part paper by Lazard Research entitled ''Equity Investments as a Hedge Against Inflation'' (Aug. 14, 2012) by Werner Kramer, which you can easily find by an online search. This excellent research provides a background to the history of inflation trends since the 1970s and looks at the industrial sectors which did the best during the two high inflation periods from April 1973 to November 1974 and from December 1976 to April 1980.

One of the key conclusions of this research paper is that stock returns tend to be negative at the beginning of an inflationary period, but that over longer periods the returns tend to recover. It is also described how companies can adapt to mild or moderate inflation over time, but that periods of very high inflation can be expected to result in negative stock market returns. This paper also looks back at what industrial sectors fared the best under the two inflationary periods in the '70s. For example, gold and oil services were found to be the top performing sectors during these periods.

However, simply investing in gold or oil services stocks may not be the right decision in today's market. During the '70's oil demand was on a strong upwards trend, and the inflationary period beginning in April 1973 was actually caused by an oil embargo by Arab oil-producing countries. But now this rate of increase in oil demand has slowed, and is stagnant in Western economies. And with gold having already corrected from a long bull run, its future value as an inflation hedge is currently less certain.

So now, in the light of current economic conditions, those concerned about the likelihood of rapidly increasing inflation need to be creative in their thinking, not just select sectors that did well in the inflationary '70s.

Predicting the consequences of inflation on different types of companies is quite challenging. I have done my best below to propose some general guidelines on the types of companies which I think could either benefit or suffer under conditions of higher inflation. I would very much welcome any feedback and additional or alternative suggestions.

Companies Which May Do Badly:

1. Companies with high debt (and a low interest cover ratio) since obviously higher interest charges on debt, which will most likely accompany inflation, will impact net profit. However this is not so straight-forward since debtors actually benefit in relation to creditors during periods of inflation since the value of the debt reduces in real (inflation-adjusted) terms as inflation continues.

2. Companies that have large projects that take several years to complete, such as large construction and engineering projects. Since the project price is under an existing contract, it will not normally be possible to pass on increasing raw material and labor costs to the client company, although many such companies will undertake some forward hedging contracts on essential raw materials.

3. Companies with a high proportion of costs for raw materials and labor. A classic example of high labor costs is security guard companies, which may have trouble passing on higher labor costs to existing clients. Many food production companies also have a high proportion of costs for agricultural commodities, and could see reduced profits if they don't have the ability to raise prices.

4. Companies with low profit margins. Changes in the cost structure will affect low margin companies disproportionately, unless the ability to pass on costs is guaranteed.

Companies which may do well with inflation:

1. In his Letter to Shareholders in 1983, Warren Buffett explained how companies with a high return on net tangible assets could often do well in times of increasing inflation. In other words, companies that do not require large additional amounts of capital spending each year may be in a position to increase prices and make a higher profit on the existing capital base. See's Candy is given as an outstanding example of an enterprise that can do very well with modest inflation. You can read more about this in Jacob Wolinsky's Oct 05, 2010 Gurufocus article entitled ''Warren Buffett on See's Candy".

2. Companies in monopolistic positions with an installed infrastructure. An excellent example here are the railroad companies. Because of their existing infrastructure which is impossible to duplicate these companies should be able to increase prices in response to an increase in the price level.

3. Companies selling high-brand recognition, low-cost consumer staples. Companies like Procter & Gamble, Nestle and Coca Cola should continue to do well since their established and powerful brands give them the power to increase prices in line with increases in raw materials and labor costs. Another recent GuruFocus article on inflation hedging by ''4percentportfolio'' entitled 'Inflation Insurance for Your Retirement'' also discusses dividend growth stocks including both PG and KO.

4. Companies whose major asset is intellectual property or goodwill, i.e. those that do not have high costs for production plant, labor and raw materials in relation to sales. Examples here could be tech companies such as Google, Facebook and some healthcare product companies.

5. Real-estate investment trusts and commodity companies including mining, oil, forestry and agriculture.

The problem with making any suggestions of course, is that many of the companies mentioned above have already increased considerably in price since the bottom of the bear market in 2009. Although they may do relatively well in response to inflation, at their current prices they are certainly not ''cheap." The conundrum is that I face two choices: either pay what I consider to be ''fairly high'' prices for stocks at the present time or wait for them to become cheaper during a market correction. But as inflation worries lead investors to continually bid prices higher, I may find that I am holding onto excess depreciated currency if I simply sit on my hands. As I wander down the aisle of my local supermarket I suddenly get a flash of inspiration, and throw a couple of extra six-packs of Bud into my shopping trolley... just in case.

Disclosure: Long PG, KO, Nestle. No position in Google, Facebook or BUD. Readers are advised to do their own research before investing in any of the stocks or sectors mentioned.

About the author:

graemew
Interested in European, US and Asian markets.

Rating: 3.6/5 (16 votes)

Comments

crazyfire
Crazyfire - 6 months ago


Hey graemew do you know about any etf or mutual fund that focusing on companies with high return on tangible assets ?
Phil_Buffett
Phil_Buffett premium member - 6 months ago


hey graemew,

nice that you are back with an article. do you not longer hold Tesco? You wrote really good pieces about it :)
graemew
Graemew - 6 months ago


Hi Crazyfire,

Sorry for my late reply....no I don't know of any etf that focuses on companies with a high return on net tangible assets. I think that it is so complex to identify the right companies for inflation hedging that a simple metric like that would not be sufficient. Of course a lot of thought needs to be put into the individual circumstances of each potential company...and to try to project what would happen in an environment of high inflation. However there are some funds available that are designed for inflation hedging. Graeme
graemew
Graemew - 6 months ago
Hi Phil,

Thanks for your very kind words about my previous Tesco article....I think I have learned from that. When I wrote that article I focused too much on the past success of Tesco and didn't look sufficiently at the potential pitfalls and future risks. The recent financial results for Tesco have been dismal with losses in Eastern Europe, the sale of the loss-making US operation, with impairment charges coming, and reduced margin and market share in the UK market. What Tesco still does have is huge property portfolio which has a market value worth perhaps 17 billion more than the value stated in the balance sheet. (sorry I don't have the correct numbers to hand.) This makes Tesco a very solid company....however I am worried about the very thin profit margins. Would Tesco be able to easily increase prices if high inflation comes? Or would customers move more towards the heavy price discounters? Would the Tesco bank customers withdraw their deposits if the company started making losses in the midst of a new financial crisis? The company is now a turnaround prospect, but I am not confident that the management has the right strategy. I recently reduced my position in Tesco, but probably I should have waited for some recovery and maybe I'll have regrets later. Graeme
batbeer2
Batbeer2 premium member - 6 months ago
>> however I am worried about the very thin profit margins.

You can be worried about a lot of things but for a grocery, you should rather be worried if margins are high. That is unsustainable.

Tesco's profit margins are thin like Costco's margins are thin. The difference between gross margin and net margin is smaller than at any of their peers. For a retailer, you want that difference to be small. This means they are more efficient. If you can get that at a low multiple on earnings then that's interesting to me.

There are two kinds of companies,

those that work to try to charge more

and those that work to charge less.

We will be the second.
- Jeff Bezos

Just some thoughts.

AlbertaSunwapta
AlbertaSunwapta - 6 months ago
^ do you look at their debt distributions? I'd say that in today's market their debt distribution can improve or impair their margin positions in a way that couldn't be done before the financial crisis. So I'm guessing that the persistence of some 'excessive' margins could be surprising. Some competitors may be unable or unwilling to lever up in response and lack near term rolling debt requirements due to prior longer term debt financing (ie they went long on their borrowing prior to the crisis and Fed intervention and so temporarily impaired their competitive positions.)
graemew
Graemew - 6 months ago
Hi Alberta,

Thanks for your comment. Yes you have a point, it's necessary to do one's homework and look at the structure of the debt, expiry dates and fixed or floating etc...not just look at the quantity of debt alone.
vgm
Vgm - 5 months ago

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