Value investor with a deep passion for understanding and a desire to improve results over time.
US Inflation History
Inflation is scary, especially if you don't remember the last time it dominated headlines in the United States (and it's scary if you remember, too!). Indeed, for four full decades beginning in the early 1980s, inflation seemed to have become a relic of the past before coming roaring back in 2021.
For most Americans, this surge seemed to have come from nowhere, but looking back at the long history of economic data kept by the Bureau of Labor Statistics, one might instead conclude that the relatively low rates we had from the '80s through the early 2020s were the anomaly, not the other way around. This raises a great question: how have investors historically dealt with high and rising inflation, and what current options are available in today's markets?
Cash and Opportunities
One crucial thing to keep in mind with inflation is that companies have both inputs and outputs that can be affected dramatically, and it's important to understand which companies are better positioned to deal with such an environment. In other words, find businesses that can pass on expenses to customers in order to survive (or even do reasonably well). Simple concept, right?
Maybe not all that simple. There's an additional component to consider: cash. After all, you might want to hold onto some cash in order to take advantage of bargains, but cash is trash, as Ray Dalio pithily puts it. If you hold cash in your account for a year and inflation is 10%, your cash is now worth 10% less than it was a year ago. Keeping any percentage of your portfolio in cash, then, is guaranteed to lose 10% this calendar year (given the hypothetical 10% rate we're using).
Why Hold Cash at All?
Using the above 10% inflation rate, holding onto $10,000 in cash for a year would leave you with $10,000 after a full year. However, your ten grand is only going to be able to purchase $9000 worth of the same stuff when it could have bought $10,000 worth of stuff just a year ago. This is clearly a losing proposition, so why on earth would you want to have any cash?
The answer is twofold. First, you might find some opportunities that are worth far more than a 10% annualized rate of return to you, and you're much more likely to find deals like that whenever there's a lot of fear in the market.
Fortunately for you (or unfortunately for most people), inflation drives more fear than almost anything in the stock market, often causing prices to drop dramatically. Many of the falling prices are going to be absolutely appropriate since "only when the tide goes out do you discover who's been swimming naked." In other words, your odds of finding a deal that makes it well worth holding some dwindling cash are pretty high.
Second, you don't have to hold the cash forever. Buffett preaches to invest through thick and thin, especially through thin, and that's because the best bargains you're going to get, and your best returns are very likely bought during the most pessimistic of times. You want to be putting your cash to use whenever conditions are scary out there (although holding onto some "dry powder" is also a very good idea).
Best of Both Worlds
While you can't have your cake and eat it, simply holding onto cash at all times isn't the only way to be able to take advantage of market mispricing. If you hold onto businesses that produce a lot of cash (dividend stocks in particular), you can generate income as you go along, replenishing some of your cash as the stocks you own pay you every quarter (or month).
Dividend Growth Investing (DGI) is among the very best strategies to use during heightened inflation, since those companies tend to hold up better than most (largely due to their ability to generate cash for you, the investor), and you may be able to put that precious income to use by buying at opportune times.
You can also consider running covered calls or cash-secured puts in order to keep the cash tap flowing into your portfolio. The important thing is to be able to tap into that cash stream when you have something to buy. The more conservative covered call strategy might not generate a lot of income for you, but it will mean you'll have cash coming in even during the very worst of times.
But Which Stocks?
So, companies that pay a dividend tend to do better, but what types of businesses are we talking about? First and foremost, look for companies with a "moat" around them, especially a moat surrounding their ability to raise prices if their inputs go up. Keep in mind that a ton of investors may be looking for the same type of business, so be careful to make sure the price hasn't already run up on higher quality, fortress-like businesses.
- Commodity producers are likely to be among the best performers, but you have to be really careful. If cash is worth less, then oil or copper is worth more cash, since they're going to continue to be bought and sold. Even if the economy slows down, people are still going to need to travel from point A to point B, and a certain level of activity is going to continue across the globe. Energy, in particular, tends to outperform during inflationary times. However, a word of caution: most investors figure this out early into a downturn, and so a higher price is often already baked in for commodities, and if you're also heading into a recession, you might be in for a very ugly ride, as demand scales back.
- Real estate can be a great hedge, since there's a relatively fixed amount of houses out there, and it takes a long time to build more. Rents can typically go up in order to match inflation, so the income offered from REITs (Real Estate Investment Trusts) can be very appealing.
- TIPS (Treasury Inflation Protected Securities) are designed to keep pace with inflation so you don't lose any of your purchasing power. If you don't mind having your cash tied up for a while, TIPS can be an excellent way to preserve your buying power; but you're limited in the amount you can purchase, so this may only be a partial fix.
It can be scary to invest in an uncertain environment, especially when inflation rears its ugly head. Keep in mind that the alternative—holding onto your cash—isn't really much of an alternative but more of a guarantee to lose money. Keep calm, carry on, and remember that you have some decent options that can help you preserve your wealth and maybe even grow it over time.
More importantly, take a moment every week or month to observe what's happening in the markets. Is this something you can learn from? Can you be better positioned before the next potential inflationary spike, or will it be too long until these conditions repeat to bear the cost of lower performance? Keeping your eyes and ears open can make a negative experience turn into an educational one.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2022 Andrew Smith