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Hedging Against Inflation

Rising commodity prices have many investors concerned about hedging their portfolio against inflation.  Here are some ideas to consider.

Bonds:

Bonds are the classic losers when inflation accelerates.  Rising inflation pushes interest rates up, bond prices down and repayment comes in a currency that has lost purchasing power.  At an earlier time when inflation was high and rising, bonds once were jokingly called certificates of confiscation or vehicles used to create long term capital losses.

If one expects rising inflation and interest rates, the best defense is cash, short maturities or shorting long bonds.  Then as bonds mature the proceeds can be reinvested at higher interest rates that embed the higher inflation.  The trick is to accurately call when interest rates are about to rise or fall.  The risk is that you make the wrong interest rate call or the right call but prematurely.  Both wrong bets can be costly.

There are bonds that float or adjust rates upward in times of rising inflation.  Others give the holder a put option at various points in time.  Generally, these bonds pay more than very short maturities but less than comparable longer maturities.  Thus one ends up paying for the inflation hedge in forgone income if the rise in inflation does not occur.

This statement is based on the theory that the yield curve embeds consensus expectations of forward spot rates.  If one disagrees with the consensus, then trades can be made to exploit the investment “opportunity” one sees.  Theoretically, these trades are made until the yield curve changes shape and a new equilibrium yield curve is established.  Given today’s large pools of money that can go long or short and the proclivity to very active trading, this academic theory holds more credibility today than in years gone by.

Our opinion is that calling unexpected changes in inflation and interest rates has no more than a random chance of being correct.  Even if one possessed the world’s most comprehensive and sophisticated econometric model, the results would be pretty random.  Why do we say this?  Human behavior changes both over time and at the extremes or new factors evolve that aren’t included in the model.  The demise of Long Term Capital and several large brokerage firms are examples we would cite.

What is one to do?  Invest in bonds to meet income and cash flow needs.  Adjust the average maturity moderately around that of the relevant index; keep turnover and expenses low.  Buy quality bonds cheap to the market and hold to maturity.  This approach should produce attractive returns versus almost any index and most other fixed income managers.

Common Stocks   

Common stocks can be good inflation hedges, especially those of companies with pricing power.  Pricing power comes in many forms but is generally possessed by industry leaders with innovative and differentiated products.  Common effects of pricing power are strong profit margins and high returns on total capital, basic criteria Cardinal Capital uses along with our multi-factor valuation model in evaluating stocks for investment.

Companies paying a rising stream of dividends are another very effective inflation hedge.  Over time such stocks can provide a rising level of real income (net of inflation’s bite).  The majority of companies in Cardinal Capital managed portfolios have both pricing power and pay increasing dividends for a solid one-two punch against inflation.
 
The stocks of many companies are direct hedges against inflation.  These include producers of energy, natural resources and agricultural products plus companies whose products are factors in the production of energy, agricultural and industrial commodities.  Examples range from large capitalization multinational companies such as ExxonMobil, Deere and BHP Billiton to smaller companies such as Carbo Ceramics and Tullow Oil.

Companies that are especially negatively exposed to rising inflation include utilities without automatic fuel adjustment clauses and any company whose prices are regulated.  Regulatory lag will cause those companies to suffer in a rising inflation environment.  Highly leveraged companies with a lot of short-term debt will also suffer in a rising inflation and interest rate environment.

Concluding Thoughts

Calling changes in inflation and/or interest rates is a tricky proposition.  Cardinal Capital believes in constructing diversified portfolios that are hedged through their composition against unexpected changes in inflation and interest rates.  These include high quality short to intermediate term bonds for fixed income needs.  Common stock investments should be focused on financially strong, growing companies with pricing power, rising dividends and high returns on total capital.  Combined with a disciplined valuation process to identify opportune buy and sell points, such portfolios should perform well under a wide variety of economic conditions.
           
Cardinal Capital Management, Inc. | Joel A. Millikan, CFA | March 31, 2011

Comments or questions?  The author may be contacted at 919-532-7500 or jmillikan@cardinalcapitalmanagement.com