Last Friday the Chair of the US Federal Reserve, Janet Yellen, said that raising interest rates may be warranted this year. If I asked Canadians how their portfolios are protected against inflation and rising rates, I’m guessing I’d hear a lot about stocks, and particularly natural resource companies. Most people would say when rates start moving higher, investing in the stock market along with energy and mining companies would protect the purchasing power of their portfolios. With Canada’s rich abundance of resource companies, inflation protection is a shoe-in, right? While on the surface this sounds good, not all stocks make for a good inflation hedge, and certainly not most resource companies.
Academic studies confirm that the ability of stocks to hedge inflation depends more on changes to the rate of inflation, and not the absolute level of inflation. For example, if inflation is stable, no matter high or low, stock prices tend to behave well. But to many investors’ surprise, if inflation begins increasing, it can actually hurt stock market performance. Rising inflation poses a problem in four ways:
First, it increases capital and maintenance costs for businesses. Imagine you run a business that requires you to reinvest all or a portion of your profits to stay in business. You may need to buy new machinery or even replace a whole factory. If inflation moves higher, it costs more to replace that property and equipment. Therefore, businesses with higher maintenance requirements, traditionally industries such as mining and energy, may actually suffer when inflation picks up due to rising replacement costs. Many businesses with higher maintenance requirements use debt to cover those costs, and inflation causes the cost of that debt to increase over time. Instead, finding companies with lower maintenance requirements is one way to stay ahead of inflation and rising rates.
Second, rising rates lift the high-jump bar. When inflation and rates move higher, companies with lower return on equity become less competitive. For example, if I expect to earn 1.5% on a government bond after-tax or 2.0% on a stock after-tax, I should buy the stock to earn a higher return. But if rates move higher, and the government bond now offers a 2.0% return after-tax (with essentially no risk), I’m more likely to choose the government bond since I will bear less risk without sacrificing return. Increasing rates negatively affects the value of stocks except for those with a higher return on equity. Companies that can grow cash flow at a higher rate will stand out as winners.
Third, inflation increases input costs. Companies that have to pay more for raw materials will have a harder time controlling costs than companies that rely less on raw materials. Brand name companies with pricing power and dominant market share are more able to pass rising costs on to consumers, unlike smaller producers or makers of commodity products. Also, companies with wider profit margins have more ability to offset higher costs than companies with lower profit margins.
Finally, not all dividends are created equal. Inflation erodes the value of dividends over time, especially in a low-yield environment. Companies that can raise dividends or buy back shares at a rate faster than inflation will be worth more than companies that cannot. Making sure that companies are increasing dividends because they're earning more and not because they're taking on more debt is also critical, as the cost of servicing that debt will increase over time.
In all, investing in the broad stock market (and particularly natural resource companies) may not be the best hedge against inflation, as many investors believe. True inflation protection requires finding companies with higher return on equity, established pricing power, low maintenance costs, low debt, and well-tuned profit margins. We don’t know exactly when rates will rise, but we'll be prepared when they do.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.