Inflation is right under your nose. On the dinner table. At the doctor’s office. But so too are potential opportunities. Learn how you might harness inflation as part of a growth strategy.
Dive into a $15 gourmet burger—beef, bacon, tomato, etc.—and you get a good sense, stacked neatly between two brioche buns, of what surging food prices do to your appetite. But have you thought about what that outsize burger, with its price to match, mean for your portfolio? Some of that premium reflects a fascination with fancy burgers and other “foodie” trends. But it’s hard to deny that costs for many raw materials—like the grain to feed the cattle and make the bun—are creeping up, even if the broadest measures of inflation so far remain in check.
Should you run from the inflation bogeyman? Or should you try to outsmart him, taking your cues from your own pantry, medicine cabinet, and garage?
Start with some basic fundamentals. Commodities, basic materials, and energy stocks tend to benefit as inflation picks up because sales and earnings increase in step with escalating prices for steel, oil, minerals, and the like. On the other hand, financials, utilities, and consumer-discretionary stocks—sectors that are particularly sensitive to interest rates—can suffer at inflation’s hand.
Next, think about which restaurants, grocery chains, manufacturers—or any business for that matter—hold power to raise prices. “Pricing power” refers to the effect that a change in a given company’s selling prices has on the quantity demanded of its products. Generally speaking, if a company doesn’t have much pricing power, then an increase in its prices would lessen the demand for its products, as consumers switch to cheaper alternatives. Thus, many stocks with strong pricing power perform well amid rising inflation because of their ability to pass along greater costs to customers.
Warren Buffett, in a 2011 Financial Crisis Inquiry Commission interview, had this to say about company pricing ability:
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.”
Think hamburgers to amber waves of grain. Yes, pure-play commodities can be used as a hedge against an inflation surge, but big bets on gold and oil aren’t usually for the little guys. The same theme can be applied to stockpicking. In recent months, prices for a few key agricultural products, including coffee, hogs, and soybeans, rallied for various reasons (see figure 1). When food commodity prices rise, farmers respond by putting more land to use or expanding livestock herds. If you believe that the commodity producers stand to benefit from rising inflation, so might the rest of the production pipeline: the heavy equipment manufacturers and seed, fertilizer, and chemical companies.
FIGURE 1: HOT COFFEE, SIDE OF BACON. A foodstuffs index tracked by the Bureau of Labor Statistics spiked to a 20-month high in early May as dry weather hurt Brazils coffee crop and a swine disease hitting the U.S. herd sent hog prices to all-time highs. Data source: BLS. For illustrative purposes only.
You can also base decisions on multiple themes. Maybe you like fertilizer companies because you expect inflation to rise over the medium term, but in the long term you expect fertilizer to be in high demand as farming expands in emerging markets. You might opt for a China-based (but U.S.- traded) fertilizer manufacturer.
Don’t forget the end of the food chain. Discretionary spending might slide in a higher-inflation situation, but people still need to eat. Modest food inflation usually helps the bottom line for grocery stocks, and the rise of specialty and high-end organic and fresh-focused brands may give better traction for pricing power.
Inflation risks could inspire you to think out of the box. Higher oil prices may encourage businesses and homeowners to consider energy cost-cutting measures. Cue the makers of energy efficiency technology, climate-control pumps, and heating and ventilation systems.
Think Better, Faster
Finding other possible inflationary beneficiaries can be more of a challenge. Developers of new products and technologies and those catering to a demographic trend can produce gains that outpace inflation—as will firms that benefit from government actions intended to fight rising prices.
Take health care. Obviously, medical costs continue to escalate, and although the government may try to provide some relief, demand stands only to increase (see figure 2). That puts pressure on blue chip pharmaceuticals, as well as the nimbler, experimental biotechnology firms producing breakthrough drugs and treatments. Of course, these are also risky stocks. Some may be just a Food and Drug Administration rejection away from a doubledigit stock price plunge. The point is, it may take this kind of risk-taking on the part of the business to forge ahead in areas of creative development, where novel products demand higher prices.
FIGURE 2: DOCTOR BILLS GETTING BIGGER. Healthcare spending (red line) has outpaced U.S. economic growth (gray) by a nearly five-fold clip over the past five decades, and the trend shows no sign of changing. Source: Center for American Progress. For illustrative purposes only.
The same may be said of the technology firms first to market with innovation to help companies operate more efficiently. Inflation means businesses must be more disciplined and efficient to maintain profit margins if they can’t significantly hike prices. Accordingly, stocks tied to software, microchips, and other technology for the semiconductor, flat-panel display, and handheld electronics industries, and specifically, output-improvement services for the integrated-circuit manufacturing process, may be worth a look. These involve technologies that help other tech firms and manufacturers run more efficiently, potentially on less labor. Although updates cost money, technology and efficiency become a fixed cost until the technology is obsolete. What’s not a fixed cost? Energy-inefficient processes and excess workers who require cost-of-living wage increases.
Beyond a sector-by-sector review, you could also consider companies that can increase their dividends at a rate faster than inflation, since that gives investors a “real-dollar” profit. That’s why dividend growth potential is just as important as current dividend yield. For similar reasons, real estate investment trusts (REITs) can be inflation-beaters. Although REITs can be illiquid, and thus riskier than traditional stocks, they tend to have relatively stable costs and have borrowed cheaply but will presumably collect higher payments as inflation pushes up rents and lease rates.
Now, simply earning an inflation-friendly badge may not be enough to make a stock a growth darling. Valuation also matters. It makes sense to beat inflation to the punch, getting into the stocks that you believe could benefit from rising inflation before inflation actually takes hold—in other words, before price-to-earnings ratios get too rich.