Protect Yourself With These Inflation-Safe Investments

"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."

- Warren Buffett


An inflationary environment is viewed as negative due to its ability to turn suspected profits into losses. If an investment in a stock, bond, or savings account produces a lower return than the inflation rate, the investor loses money. Due to this possibility, years of positive returns can fade into nothing if invested in the wrong assets.


Inflation hurts the economy because it erodes the value of cash, meaning a dollar will not buy as much tomorrow as it does today. For example, in the diagram below, the $1.25 that buys a single cup of coffee in 2010, would not be enough to pay for the same cup in 2019. The price is increased to $1.59 because of the decreased value of the currency.

There is little need to worry in an inflationary environment, however, if the correct assets are selected. Historically, there are some asset classes that are safer and have outperformed during times of inflation:


1. High-quality companies with pricing power


Since the dollar is worth less from the effects of inflation, prices must rise to maintain the relative worth of products and services. This means businesses may not be as profitable as a result of having to pay more for inputs and labor in production. The damages that this causes for a business should be worrisome for investors. Lower profitability due to rising input costs can make the difference between a company operating at a gain or a loss, hence negatively impacting stock price as investors see the inability of the business to make money.


High-quality businesses that have the capacity, known as pricing power, to raise prices without losing volume, can maintain sales and profitability during inflation. Investing in a company with pricing power helps prevent the negative effects mentioned above that are caused by higher input costs. These investments are typically in areas where demand is highly inelastic, such as consumer staples and biotech. Inelastic demand for a good or service represents the concept that as price changes, the overall quantity demanded for that product is barely affected. For example, people need to buy food and medicine, whether inflation is present or not, because they are essential products in day-to-day life.


Even with higher prices, consumers remain willing to pay for a product or service that they truly need. Therefore, pricing power is key in an inflationary economy – the higher price is absorbed by the consumer due to inelastic demand. When there are very few alternatives to the company's product, people have no choice but to keep buying it, especially if it is an essential item in their lives. Rather than the firm enduring the negative impacts of higher costs, they leverage their pricing power to retain high levels of profitability, as long as demand remains relatively equivalent to its levels before the price increase. At the same time, this ability brings both the company and its investors greater comfort and stability through rougher economic conditions.

Companies that have the most pricing power are near-monopolies. A great example of this is Anheuser-Busch with its ownership of multiple top-selling beer brands. They control over 40% of the world’s beer profits as well as produce about a quarter of the beer supply. With strategic acquisitions over the past few years, Anheuser-Busch remains in a good place to continue this near-monopoly. Since the company controls a significant amount of production, they also have the capacity to use pricing power, raising or lowering their prices to retain profitability. Beer, classified as a consumer staple, also has fairly inelastic demand, so consumers will continue buying Anheuser-Busch's products independent of the economic condition.


Moving to utilities, another essential service, many of the same benefits of companies with pricing power are offered to investors during inflation. Utility companies provide amenities like water, electricity, and natural gas to both residential and commercial properties. Maintaining much of the public infrastructure and providing services that people cannot live without, like heat, air conditioning, and water, utility companies see little change in demand during inflationary times.

2. Real estate or other long-contract assets with inflation protection


There is another group of assets that perform at a higher caliber throughout inflationary pressures, all having contracts that allow for price increases. Rental properties, power plants, and gas pipelines, for example, are all very stable in their cash flows while building pricing power into their contracts with consumers. These assets, like utilities and biotech companies, have considerably high inelastic demand. Housing and energy production and infrastructure are essential for everyday life. During periods of inflation that bring higher prices to most items, people are willing to sacrifice their discretionary spending to pay for their mandatory expenses, like a place to live.


Pertaining to real estate, investors should avoid properties and companies that do not allow for the increasing cost of inputs to be passed on to the end consumer in their contracts. Rent-controlled real estate is susceptible to the pressures of inflation, significantly impacting profit margins. The advantage of pricing power in real estate is the ability to raise prices coupled with the stable, monthly cash flows collected from tenants.

Another appeal of real estate is the fact that mortgage payments are fixed, which means any increase in monthly rent is additional profit. For example, if a 30-year mortgage requires $4,000 payments per month and the current rental rate of a property is $5,000 per month, the rental rate can be increased to $5,500 per month with the use of pricing power. This changes monthly profit from $1,000 to $1,500, a 50% increase in rental income.


Below is a graph of the performance of equity REITs compared to the S&P 500 during the high inflation in the late 1970s and early 1980s. The dominance of real estate during inflation is illustrated in the graph, which is important because many economists are comparing the current economic environment to this period of time.

Data Sources: reit.com; macrotrends.net


3. Businesses purchased at a discount to their intrinsic value


The final mode of navigating investments through inflation, as mentioned above, is buying a business that is worth less than its intrinsic value. As opposed to the other investments discussed in the article, these businesses do not need to have significant pricing power. Sometimes the market does not realize the true value of a company, giving investors a great opportunity to capitalize on an undervalued business.


To demonstrate the power of this strategy, take a company that is, for example, worth $100 but priced at $50. Due to the company’s ability to generate increasingly positive cash flows, the stock price rises to the intrinsic value over the course of three years from the time of investment. If we can ascertain that the long-term fundamentals of a company are unchanged, then over time the company will reach its fair value. In other words, within typically 2-3 years the company will go from $50 to $100 with annual returns of 25%. This is multiple times higher than the current inflation rate of about 8%, which could be a great way to outpace inflation.

It is important to intelligently invest across all market conditions. However, the best way to do this is to combine the first and third strategies listed above. High-quality companies with pricing power that are also selling at a discount to their intrinsic value are the most favorable approach to navigating uncertain inflationary periods. An investment that has both of these qualities at the same time would most likely prove to be an ideal asset to hold through any economic environment, including the market conditions existing today.


By: Siddharth Singhai and Cole Stephenson

Disclaimer


Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.