People have been talking about investing in gold for a while now. As Peter Schiff likes to point out, in the Roman Empire an ounce of gold purchased a Roman citizen a toga (suit), a leather belt, and a pair of sandals. Today, one ounce of gold will still buy a man a suit, a leather belt, and a pair of shoes. So gold is definitely a long term inflation hedge. But here are the cons of investing in gold and some other inflation-hedge options.
Cons of Gold:
1) Gold has large volatility and long periods of time (like 20 years around the 80s) when the prices won’t go anywhere.
2) From a contrarian standpoint, we hear way too much about gold now in days. Everyone knows about Cash4Gold etc. For your cash-type ready-to-use money, other useful commodities that have not increased in price as much as gold yet might be better. Oil, Iron, copper, etc. are all great inflation hedges for the same reason as gold. No one can print them. They take hard work to find and unearth, and thus have intrinsic value. And they are not on late night infomercials… yet.
Option 1 – Better -than- gold Tier I stocks
Asset-backed / Necessary-Goods stocks: Gold is *only* an inflation hedge. In the long run you are much better off with a company that is producing something useful, since, over time that company can be worth more, not just the same. So for example any asset backed / commodity stock (oil, energy, food) is a better inflation hedge. The value of any asset backed /commodity company will get automatically adjusted for inflation, which will be reflected in the stock price. A better hedge against inflation is a company that sells something that people will always need, even when they are broke and thus, has a competitive advantage. So they can quickly pass along price-increases and potentially grow your money profitably. Examples of companies like this might be Johnson and Johnson, 3M, etc. On top of inflation-adjustment, you will also see the usual returns/ losses of investing in businesses. It might get hard to decouple the two, but you won't be "wasting" your dollar because of inflation.
Option II - Even- better inflation hedge – Tier II Stocks
Necessary-Goods Companies with High Leverage: The dream inflation hedge would be in a company that apart from selling ever-needed products with a steady stream of earnings (what we call the Tier-I stocks) and having some competitive advantage is also heavily leveraged. Then if inflation does happen, they would able to easily pay back their debt in much cheaper dollars. Now you’ve got a hat-trick - a company with real value, that make something people need, has pricing power and is actually taking advantage of inflation to pay off their debts. Warren Buffett’s purchase of Burlington Northern is a brilliant inflation hedge as it satisfies all these criteria to the T. Large moat, steady earnings, asset based, highly leveraged, and good potential for growth.
Aside: Alternatively, you can take on personal leverage as well, you might be able to find a company that satisfies the dream criteria above AND pays a dividend that will cover the cost of margin for example. Also just taking large loans can make a good inflation bet since you would be able pay them back for a fraction of their original "value". This assumes two things though. 1) You can continue to make the payments. 2) You invest the money in something of value. For example you could buy a house on a highly leveraged basis, subsidized by Uncle Sam.
Option 3: Best bang for your dollar-buck? – Tier III stocks
Highly-Leveraged Necessary-Goods Companies outside the US: The third option is to could invest in tier-II stocks outside the US (the Euro or the Yen for instance) if on top of inflation you are worried about the dollar losing value because of a demotion from its current place as a global currency standard. A global currency standard means that if a French bank and an Indian bank need to conduct a transfer, they would both have to transfer their currency into dollars, transfer the money and then back again. The same is true for buying oil. This means that there is an additional "artificial", if you will, demand for the dollar effectively raising its intrinsic value. There are now talks about replacing the global standard with the Euro, or Yen, or a "bag of currencies" - if this happens, there will a related devaluation of the dollar, which has nothing to do with inflation. For this you could check out countries that Peter Schiff recommends in his book “Crash Proof”. Australia and New Zealand come to mind.
These are fun times we live in. Smart moves can give über -smart returns.
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Isn't a highly leveraged company run into the risk of not being able to pay back its debt, even if the dollars are now cheaper?
ReplyDeleteJust because a company ( Johnson and Johnson, 3M, etc.) will prosper does not necessarily mean someone who buys their stock today will prosper. It depends on the price you pay for it. If stocks are overvalued now and then undervalued later, your company might survive but you will take a financial hit. I'm not saying stocks are bad; I'm saying they're only good if the price is appropriate.
ReplyDeleteHowever I can't tell if you're being ironic, since over-leverage is exactly what caused the recent financial crisis and you're so starry-eyed about both corporate and personal debt.
On the question of price: A basic tenant of investing is to assess a potential investments value and to buy it a price which is lower than that value. That however is not the subject of this post. This post is meant to discuss which asset classes we feel will best weather inflation. It’s about where to hunt, not which animal to bring down. Any companies mentioned are examples of the types of companies in a class. They are not investment recommendations.
ReplyDeleteOn Leverage:
First I’d like to reiterate why leverage is good in an inflationary environment. If you borrow dollars today and but real asset, then you can pay off the dollars latter when they are worth much less. For example the father of a friend of mine lived through one of the 20 hyperinflations what has occurred since 1980. He was able to pay off his mortgage with literally a wheelbarrow of cash. Now, the key is will you be able to get the cash when the time comes.
Leverage is a lot like alcohol in that some people can handle a lot more then others. One big factor in tolerance for alcohol is weight. Take two people who don't drink and the lighter one will generally be affected faster. In the case of leverage the key factor is earnings stability.
You want a safe margin between your interest payments and you lowest expected swing in earnings. For example Take-Two Interactive Software, Inc. a company that makes video games and lives by the next hit can handle much less leverage than JNJ which sells necessities. Take a look at their operating earnings over the past 10 years.
Operating income:
Ttwo:27.4, 45.1, 25.8, 122.7, 163.0, 102.1, 40.0, (187.2), (126.1), 115.9
JNJ: 5,704.0, 6,389.0, 7,595.0, 9,195.0, 10,338.0, 12,830.0, 13,223.0, 13,821.0, 13,127.0, 15,988.0
Take two is all over the place while JNJ is nice steady predictable upward sloping line. So JNJ can handle a lot more leverage because it has predictable income.
Now to safely hold significant leverage in an inflationary environment you want to have two things. First as discussed, you need steady earnings so think of things that people need often like baby formula, razor blades, as opposed to large or luxury purchases that can be delayed like a car or a new Kindle. The second and equally important in an inflationary environment is pricing power, and this mean a competitive advantage of some sort. You don't want to muck about in a price war with panicking competitors who are trying to pay their bills. (on competitive advantage I recommend “Competition Demystified” by Greenwald)
Bottom line:
The sad truth is that inflation is bad for everyone except those who get to spend the new money before it is devalued. Even the best Tier II stocks discussed above will not do as well as they would in an environment with a stable money supply. They’re just the best options available.
For perspective I recommend Warren Buffett’s 1977 article “How Inflation Swindles the Equity Investor” which is a nice assessment of what actually played out in the horrible inflationary days of the 70s.
http://www.valueinvesting.de/en/inflation-equity-investor-by-warren-buffett.htm