Inflation at the Gates, Part 2
Brian Ransom, CFA ®, MBA, MS
Signature Wealth Management Group
As mentioned in Part 1 of Inflation at the Gates, the ultimate goal of investing is to maintain buying power over a long period of time in order to reach investment goals. Bonds and cash tend to react poorly in long-term situations where omnipresent inflation is consistently chipping away at your buying power. Equities tend to be the best income-producing asset (with the exception of perhaps rental properties) at maintaining long-term purchasing power.
There are some nuances, though, as not all equities are created equal on the inflation scale. Basically, protecting your portfolio against inflation isn’t a “one-size-fits-all” approach. There are many different variables that can affect a stock price. But here are a couple of different “ideas” that can help mitigate damage to a portfolio caused by inflation.
The go-to answer to this question is typically energy allocations and it is the most straight forward answer as well. Because inflation is typically caused by commodity price increases that trickle down through the rest of the economy, having exposure to a company that actually benefits from those price increases can be a good idea. Here’s Exxon Mobil (NYSE: XOM, blue) performance through the inflationary years from the 70’s and 80’s, where core consumer prices (red) peaked at 14% year-over-year.
Over the course of three years, Exxon returned over 80% as the price of oil doubled over that time period. There is a drawback to energy investing, however. It’s a highly cyclical industry. As CPI peaked in 1980, it fell 42% to 1982 effectively wiping out all gains during that time period. Thus, the conundrum, energy is a great sector for when commodity prices rise but likewise a poor option for when they fall.
There is a theory in finance that brand recognition carries a certain value premium. This value premium allows a strong brand to enjoy wider market penetration, a larger market share, and most importantly, fetch a higher price capturing a greater margin. As an example, I think most consumers would prefer Coca Cola over RC Cola and be willing to pay a bit extra for it. The stronger the brand name, the more willing the general consumer is to pay rising prices for the product.
Coca-Cola Company (NYSE: KO, blue), despite being a staple with heavy exposure to rising commodity pricing and rising interest rates, has done remarkably well over the last year, outperforming the rest of the equal-weighted staple index (red).
Even during the rough stock market in the late 70’s and early 80’s, Coca Cola performed remarkably well. Between 1977 and 1983, Coca Cola (blue) was at most, down 26% right as inflation (purple) peaked. Compare that to International Paper (NYSE: IP, red), which had no brand value to speak of, which was down as much as 55% during the same time period.
While comparing International Paper to Coca Cola is a bit like comparing apples to oranges, creating a product that consumers will buy no matter how quickly the price increases can be a powerful advantage for a company (and their respective stock) at maintaining their margin. Maintaining a margin is the key to getting through inflationary time periods.
The problem with investing in energy or brand names is that it can sometimes be subjective and even require market timing. There is another way, however, and that’s to focus on dividend income and growth of that income stream. This strategy is less subjective, more predictable, and allows the investor to disconnect from the day-to-day fluctuations of stock prices.
Let’s assume John Smith has accumulated a portfolio value of $1,000,000, invests the portfolio in dividend-paying stocks yielding 3% (very achievable in today’s market), and the stocks have the propensity and wherewithal to grow those dividends at 8% (the median S&P 500 dividend growth rate is
6.5% since 1990 so this is very achievable as well). That portfolio provides $30,000 per year growing at 8%, annually.
Let’s also assume inflation for the next 30 years averages at 4% (very high over a 30-year period). Social Security pays John Smith $20,000, growing at the rate of inflation. And John Smith has a pension that pays $30,000 that does not adjust for inflation. Finally, the current income needs for John Smith are $80,000 a year in retirement (which must be adjusted for inflation).
As illustrated below, on Day 0, the pension, social security, and portfolio income provide 100% of John’s income needs (Total Income = Income Needs). As time passes on, the pension becomes a smaller and smaller portion of the portfolio’s Total Income thanks to inflation. Likewise, social security remains a relatively small portion despite growing at the same rate as inflation simply because it started off at a much lower starting income. But the growth of the dividend helps supplement the income, exceeding the income needs in the later years (Portfolio Income > Income Needs).
Investing based on income, rather than principal, allows the investor to make more objective decisions rather than subjective decisions. How do you know when you should sell Exxon in 1980? Well, perhaps it’s when the yield falls below a certain threshold and there are higher yielding stocks in the market that also have the propensity to pay and increase their dividend. This makes income-based investing a powerful tool in maintaining and growing purchasing power over long periods of time.
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1. FactSet Research Systems. (n.d.). XOM & Core CPI Y/Y% (Interactive Charts). Retrieved June 24, 2022, from FactSet database.
2. FactSet Research Systems. (n.d.). KO & Equal Weight Consumer Staples (Interactive Charts). Retrieved June 24, 2022, from FactSet database.
3. FactSet Research Systems. (n.d.). KO, IP, and Core CPI Y/Y% (Interactive Charts). Retrieved June 24, 2022, from FactSet database.
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