Shaping a portfolio for 2011: investing in a world with inflation

The way I’m reading the US stock market, investors are only now beginning to discount the possibility that the Fed will be successful in creating inflation through its QEII operations.

important stuff

The last time the US saw rising inflation was in the late 1970s and early 1980s—the pre-Volcker era.  This means that virtually no professionals active in the stock market today have actually worked in an inflation-conscious environment.  In other words, many people will talk in confident tones about the characteristics of inflation—just as they spoke about deflation—without having any knowledge other than wheat they obtained from books on the subject.  Some of these ideas may be really wacky—and translate themselves into actions in the market that, in the final analysis, will make no sense.  These oddities will, at some point, present opportunities for profit.  But it’s always dangerous to put yourself in front of a moving train—even if you know it shouldn’t be there or is moving in the wrong direction.

The key to enduring inflation or deflation is consumer expectations.  Changes in expectations translate into changes in purchasing patterns.  In a deflationary mindset, consumers purchase only at the last minute, since the trend of prices is down.  In inflationary times, in contrast, people purchase in advance of their needs, since they believe that prices will be higher if they wait.

For companies, this means, among other things, a change in behavior toward inventories.   In a deflationary environment, companies want to be as lean as possible.  During inflationary times, in contrast, companies try to achieve profits from holding inventories that rise in value before they’re used.

winners and losers

income statement

In a situation where costs are steadily increasing, the key question for profits is whether a firm is able to pass these extra expenses along to customers, and how quickly it is able to do so.  Companies that have  unusual, scarce, or sharply differentiated products will typically do well.  All other things being equal, the shorter the supply chain, the better.

On the other hand, companies in industries like utilities, where prices are highly regulated, may face strong resistance to raising prices at all, or at the very least a significant lag in their ability to do so.  Commodity-like products—ones where there are readily available close substitutes—like consumer staples, will also tend to suffer.

balance sheet

In an inflationary environment, prices rise.  The cost of money, that is, interest rates, is one of those prices.  So companies with fixed-rate debt, which usually means outstanding bonds rather than bank debt, benefit.  So do firms holding large amounts of real estate.  Capital-intensive firms that already have ample capacity, especially in industries where rivals are becoming capacity-constrained and must add plant and equipment at now-higher prices should also benefit.

my thoughts

It’s not clear how or if quantitative easing will work.  It’s also hard to predict exactly how Wall Street will respond, given that only professionals working thirty years ago have seen inflation at work while they’ve been on the job.

Having said that, one sea change already appears to be occurring.   Investors seem to me to be more conscious of the risk in holding longer-term fixed rate bonds—the clearest losers in an inflationary time.  That concern is starting to flow into the stock market, I think, where the closest analogues, that is, the most bond-like securities, are those whose dividend yields are their greatest (or only) attractions.  I think high-yielding cyclical companies will be ok, but utilities and consumer staples are at risk, because they will likely struggle to achieve inflation-matching earnings increases.  This means they must either up the proportion of income they pay out to shareholders, or let their dividend decline in real terms.  Income-oriented investors already seem to me to be shying away from situations where they must forgo dividend growth possibilities in return for high current yield.

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