A topic that was quite pervasive the past few years was the fear of inflation, with the Federal Reserve injecting massive amounts of “quantitative easing.” Whether right or wrong I am not sure, but the result was overwhelming fear of inflation.
This fear was exacerbated by the media. The media reports news that sells and not always news of importance. This results in a snowballing effect. Government provides quantitative easing –> fear of inflation –> mass news reports on inflation –> spreading fear –> effect compounds.
With that said, there was a massive rise in demand for precious metals. ETFs and funds for gold, silver and precious metals were being driven up in addition to new funds being created. I personally have purchased GLD, not as an investment but as a Las Vegas style speculation. (a very small position in my portfolio). Even though it had a return over 90%, it is not a position we would purchase for clients as it is speculative and not an investment.
At Lodestone Capital Solutions, we use the definition of investment as something that requires fundamental analysis in addition to a margin of safety. We invest in a firm with the perspective of being a partial owner. As a partial owner of a business, we want to invest in profitable companies, generating returns through growth, increases in assets and/or dividends. In other words, creating wealth for us. Precious metals are generally used only as a store of value. (Precious metal miners are a different story) They do not produce a good or service and do not create wealth. This makes them speculative in our book. Speculations are purely based on macroeconomic events, guesses and predictions.
People often overlook equities in general as an inflation hedge. Inflation hedges are often associated with commodities, precious metals, or inflation protected bonds. But just thinking about how inflation works within a company will start to make sense.
Let us imagine a company called Waterbuckets Inc. They create water buckets. They have the following information.
They have a plant in Texas worth 1 million dollars. They financed it with 50% equity (cash contribution) and 50% debt (loan from a bank at 5% for 10 years) It takes them 10 dollars of sheet metal and 5 dollars of labor to create 10 water buckets. This is a cost of 15 dollars for 10 water buckets or 1.50 per bucket. Let us then say the retail price for this water bucket is 3 dollars. They sell 100,000 buckets a year. This being revenue of 300,000, cost of 150,000 and profit of 150,000.
1 million dollar plant financed 50/50
1.5 cost per bucket to manufacture
Bucket sale price of 3 per bucket
1.5 profit per bucket x 100,000 sold per year = 300,000 gross revenue, 150,000 net profit.
150,000 net profit – 56,413 debt repayment (annual payments for 10 years) = 93,587 net income.
Then, there is a burst of inflation of 50%.
What would happen? The first thought is, the cost of creating all the goods increase, thus compressing profit margins and reducing earnings. Yes this is/may be true. But there are more moving parts.
1.50 million dollar plant.
2.25 cost per bucket to manufacture
Bucket sale price of 4 per bucket.
1.75 profit per bucket x 100,000 sold per year = 175,000 net profit.
175,000 net profit – 56,413 debt repayment = 118,587 net income.
As these are imaginary figures, there is a lot that is not accounted for, but it shows a few important items. First, the elasticity of the product determines who bears the cost of the inflation. More often than not the costs are shared between the producer and the consumer. So with inflation increasing by 50%, part of it was absorbed by the firm and the rest by the consumer in the form of higher prices. Items that are are hard to replace or switch to/from (such as companies with strong moats) generally have better pricing power and are more durable in inflationary times.
The second item, is a bit more subtle. Think about what inflation is. It is the loss of purchasing power. If you lend a friend 100 dollars to buy a bike and 20 years later he pays you back. That 100 dollars will not buy you a bike, it might only buy you half a bike. The same situation works with debt as well. The 500,000 borrowed from the bank at 5%, is worth much less after the 50% burst of inflation. So it can be said that firms that are asset light and debt heavy benefit from high inflation and firms that are asset heavy and debt light are hurt with inflation (with exceptions as always)
One last general way to think about inflation is. Say inflation doubles the cost of everything in 10 years. All else equal and neutral, income and profits will double as well. This result is a change in what is called the price level, but no change in real purchasing power. So a car might cost 80,000 instead of 40,000, but your income of 100,000 will be 200,000 with no actual change.
All else equal/neutral, if the cost of everything doubles, the earnings will double for the companies in your investment portfolio. In the above example, if the cost of the bucket doubles from 1.5 to 3 and the retail price of the bucket goes from 3 to 6 (keep in mind the consumer does not mind this because his income has doubled as well), the net profit will be 300,000. So earnings will roughly double.
So if the stock for Waterbuckets Inc originally sold for 15 dollars a share and earned 1.50 a share, it would trade at a P/E of 10. If it’s earnings doubled to 3 dollars a share, it would be 15/3 or a P/E of 5, assuming all else equal, this would be low and the stock price would be bid up to 30, which would equal a P/E of 10 again. (not true in real life, as markets are not efficient)
This is not to say equities are a perfect hedge against inflation. It is only to say that they have components of a hedge. That combined with real returns over time, will outpace inflation in the long run. This is also not to say that bonds are not useful in portfolios nor needed in retirement portolios for the older generations.
Disclaimer: Long GLD with intent to sell at time of this writing.