Among financial commentators, there is a raging debate over whether inflation is transient or persistent.
The problem with the argument is that it is almost impossible to know who is likely to be right. Both sides have rational and intelligent analysis arguing why inflation may or may not be transient.
Why are we undecided?
One of the most important functions is to know when you are very likely right and allocate capital to the probabilities of being right. In 2011, we had a strong conviction that the Aussie dollar would fall significantly to below the long term average.
Today, we are in sitting on the fence.
If the Aussie dollar was 50c, we would be wildly bullish on our currency.
At the extremes in a self righting systems, the probabilities are very much in your favour.
In the middle of a self righting system, picking direction and magnitude of that direction is as accurate as throwing darts at a dart board blind folded.
During a period where interest rates are negative in a third of the world, stimulus is higher than any time in history, the virus is still mutating, commodity prices are extremely volatile, supply chains are being disrupted and capital flows are moving around the markets at rates unheard of, guessing which way economies and inflation will run is like trying to pick the trifecta in the Melbourne Cup.
Whilst we are unclear as to the permanence of inflation, it does not mean that we are inactive in preparing our portfolios for the possibility of it.
So what can you do?
Own companies with high margins.
Own companies with pricing power
Own companies with net cash and buying back shares
Own some gold companies or gold
Own some inflation linked bonds
Own some floating rate notes
Own companies with high interest coverage
Avoid low yielding assets dependent on permanently low rates.
Own real estate which is not overpriced
1. Own companies with high margins
Companies with high margins should be able to withstand inflationary pressures better than low margin companies.
A company with a 30% net margin can handle an increase in costs such as commodities, interest rates and wage pressure far better than a company with a 3% net margin.
2. Own companies with pricing power
Ideally, you can buy the high margin company that also has the ability to raise prices inline with the rising cost pressures.
3. Own companies with net cash and buying back shares
Companies that have net cash and are buying back shares have a self righting mechanism. If the share price falls due to inflationary pressures, then the lower prices can lead to increased returns for shareholders over time.
4. Own some gold or gold companies
Gold has proven a reasonable store of value over thousands of years. During periods of sustained inflation over more than a decade, gold should provide some element of protection against the devaluation of fiat currencies. Gold stock are generally out of favour and so may provide some operational leverage to a rising gold price due to inflation. Rising interest rates may place an opposing pressure.
Temporarily, crypto currencies, mainly Bitcoin is taking the shine off gold (pardon the pun). I think that there is almost no scenario where governments don't regulate the wild wild west in crypto land for anti-money laundering and sanctions violations. At this point in time, gold will likely regain some favour. Gold is likely to be a benefactor of crypto regulation. I think it is a very high probability this occurs in the coming years.
5. Own some inflation linked bonds
Inflation linked bonds can provide a protection against rising and sustained inflation.
6. Own some floating rate notes
Floating rate notes can provide a protection against rising rates due to sustained inflation.
7. Don't overpay
There are currently a number of companies trading at prices that require everything to go right. Paying 20 to 90 times sales (sales not earnings) is potentially hazardous to your wealth if rates rise, particularly if these companies need constant capital injections to keep the lights on.
There are also a number of companies that are high quality businesses, that are trading at very high price to earnings. These companies require significantly higher than GDP growth to persist for very long periods to justify these valuations. Many of them are likely overvalued for any sniff of higher rates.
8. High interest coverage
If you do own companies with debt, ensure that the interest coverage is high.
9. Avoid low yielding assets dependent on low rates
Property prices in some Australian cities are at stratospheric levels. If rates rise, these prices may not be repeated for many many years.
Low bond yields could be problematic in a rising rate and persistent inflation environment.
10. Own real estate which is not overpriced
They are not easy to find, however there are still pockets of real estate available in Australia with net retail yields above mid single digits.
We know a person who recently bought property with yields above 10%. Many know our extreme caution when buying residential property with 1.5% net rental yields. We are not bearish on properties with high yields in areas that will have higher population in 10 years.
Prepare, don't predict.