Protecting a portfolio against the scourge of inflation is a challenge. Historically, equities have been a good hedge against inflationary forces as an asset class, but past performance should never be used as a guide to future potential, and inflation can destroy companies that do not have long-term relevence.
What's more, when I say equities have been a good hedge against inflation, I mean equity indexes. Not all individual stocks and shares have the qualities required to move through periods of inflation unscathed.
Companies with inflation protection
There are really three different types of companies that have the qualities needed to deal with rising prices.
The first set of companies are those with hard assets. Companies such as real estate investment trusts are a perfect example. The value of real estate increases faster than inflation in the long run, and rental contracts are linked to inflation. If prices rise, companies will be able to increase rent faster than inflation and offset higher prices overall.
However, it is not good enough for investors to acquire any company with hard assets. Some businesses are just not good investments no matter what the macroeconomic environment.
For example, steel producers tend to own a lot of plant and equipment, but these assets depreciate in value. They need consistent reinvestment to maintain their durability, and this investment does not necessarily generate higher returns. Many steel companies have to run fast to stand still.
These types of businesses do have some form of inflation protection because they own hard assets, but they do not offer a complete package of information protection. Therefore, they are not particularly good stocks to own.
The second bucket of companies that may offer some protection against inflation are those with strong brands. Companies like Apple (AAPL, Financial) can increase prices to offset higher input costs. The group can also increase the cost of its subscription services almost instantly, and consumers are unlikely to cancel in large numbers.
A company like Coca-Cola (KO, Financial) exhibits similar qualities. However, there are a couple of key differences. Apple can pass on price increases almost immediately to its service customers, but Coca-Cola has to wait for price hikes to move through the system. There are also more competitor products for Coca-Cola than Apple.
Consumers are much less likely to switch away from a product if they have an emotional attachment to it, which is generally the case with iPhones and other Apple devices. Many of these devices are also sold on multi-year contracts with carriers, locking consumers into the service for a set period.
I would also add a third type of company to the firms outlined above: the company that can operate at a lower cost than its competitors. I'm not talking about cutting costs here; I'm talking about companies that already operate at lower costs and are used to this business model. Economic research shows that during periods of rising prices, consumers shift their purchasing habits away from premium brands to lower cost and bulk items.
This could benefit companies like Costco (COST, Financial). Even though the business will still need to pass rising costs on to consumers, it will be able to use its economies of scale and membership fee-based business model to push through lower cost hikes than its peers, and it will be increasing its prices off of a lower base line. These advantages could help Costco outperform in an inflationary environment by capturing market share from competitors, which are pushing through more significant price increases.
Unfortunately, there is no set of rules or guidelines which one can use to determine if a business is well-positioned to deal with rising inflation going forward. Every company is different, and every company will deal with rising prices differently. Every consumer will also deal with rising prices differently. Indeed, if wages expand at a similar rate, consumer purchasing power will remain steady. This may mean purchasing habits remain the same. There are plenty of different factors for investors to consider.
