Inflation Asset Strategy: Areas to Focus on
Last week, we concluded that assets can become more or less valuable as inflation changes. For example, bond like assets in a rising inflationary environment will be worth much less than assets that are able to protect cash flow by raising prices. Imagine a stream of cash flow that increases with inflation, versus a constant stream of cash flow that does not. As investors, we should focus our portfolio on assets that will be able to protect cash flow in inflationary terms by being able to adjust to the economic environment. However, nothing comes for free. Variability adds a level of risk and there is an inherent volatility with cash flow generated from a company. The alternative, a stable cash flow stream in a volatile pricing environment, is also risky, just in a different way. A nominal return on a bond (i.e. before inflation) would generally be considered low risk; however, in a real environment (i.e. after high inflation is subtracted, for example) it is guaranteed to lose money over time. Let us consider three types of companies:
- We have already mentioned the railroads, and in particular Canadian National Railway Co (TSX:CN). The company has a network reaching across Canada and deep into the United States. It also has connection and ownership of container shipping terminals. The network is irreplaceable and no matter what happens with inflation, goods will need to be shipped to people and businesses, so there should always be demand for the service. CNR has enough industry power to require its customers to enter multi-year contracts with price adjustments for both inflation and fuel changes. This provides great protection for an investor who is concerned about inflation over the medium to long-term. Indeed, the position would not be without risk as an economic slowdown could impact demand and the ability of the company to extract price concessions, but it is a good option.
- Let us also consider a consumer products company like Nike Inc (NKS:US) whose brand is so strong that it can adjust prices to pass through labour and commodity price increases with ease to a broad set of customers who will buy solely based on the brand power. Again, not without risk because a brand can be impaired, and an economy can go into recession, but also a good option.
- We also previously mentioned technology companies as potentially a source of risk because their cash flows tend to be far in the future and would therefore be valued less today if inflation expectations increase. However, there are companies like Microsoft Corp (MSFT:US) and Apple Inc (APPL:US) that have elements of both types of companies that we mentioned above. Microsoft is an irreplaceable utility that most companies cannot do with out and Apple has a powerful brand that allows them to raise prices when needed. Both are great operators.
“This means that” that as inflation increases, we have options as investors to identify companies that provide real protection. Next week, we will discuss a few industrial sectors that, in our view, should be avoided.