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Insulation Against Inflation

Morningstar UK | 12-03-12 | E-mail Article

Although it's difficult to know how fast or for how long inflation will rise, the fact that inflation will impact your portfolio's long-term returns is a certainty. It's therefore worthwhile for investors to find ways to protect and hedge their portfolios against inflation risk.

There are numerous tactics for trying to protect your hard-earned assets from inflationary pressures, investing in equities being one of them.

Categories such as inflation-linked bonds provide an explicit hedge against an unexpected spike in inflation rates. But when it comes to an asset class with a shot of actually outpacing inflation over long periods of time, stocks fit the bill.

In an effort to identify equities with solid inflation-fighting characteristics, we sought the guidance of Morningstar US equities strategist Paul Larson. He shares some pointers for unearthing companies that will tend to be resilient in inflationary environments.

Consider the business model

Larson notes that certain business models stand a far better chance at withstanding inflationary pressures than others. Investors should focus on companies that have sustainable competitive advantages because they will be able to pass along price increases to shareholders far more efficiently than companies that are busy fending off competitors.

Moreover, firms that provide necessary products or services are better-poised to weather inflation than those selling discretionary wares.

"In periods of high inflation you can also experience a concurrent recession in which discretionary expenses get put on the backburner by most consumers," Larson says.

Larson also notes that "regulated utilities or companies with annuity-like business models might not be the best bet in a high-inflation environment because they will see the real value of those annuities fall".

Ditto for companies in the financial sector that have largely fixed earnings streams in the form of interest income. (One mitigating factor, he says, is that "a bout of inflation would increase the value of financial firms' collateral, mitigating loan losses".)

Keep an eye on the balance sheet

In addition to assessing a business model's sustainability - or vulnerability - in the face of higher prices, Larson also cautions investors to avoid firms with huge cash stakes or debt on their books.

Companies that fall in the former category will most likely see inflation erode the purchasing power of cash, while firms that fall in the latter category might not be able to endure a concurrent recession.

However, Larson also notes that "a company with a mild amount of debt (that will fall in value in real terms) that can be very easily serviced with cash flows might be in the sweet spot in this scenario".

Seek globetrotters

Looking for geographically diversified businesses is another one of Larson's key pieces of advice for the inflation-conscious. The reason? If inflation causes sterling to drop, companies that have geographically diversified revenue streams will tend to hold up better than businesses that focus on the Thailand.

Checklist

So to summarise, Larson's checklist for seeking equities to stave off inflation is:

1. Look for companies that provide non-discretionary products/services;

2. Look for companies that have at least a narrow economic moat, preferably wide (because a moat should confer some pricing power);

3. Look for companies that do not have large amounts of debt. (Companies that are mildly levered are actually best, but debt is a bit like alcohol - a little consumption is actually a healthy thing, but it can be highly destructive if used in excess.)

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