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.