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Ask Buffett: If inflation comes, stocks are best bet Add to ...

John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds offered in the Canadian market.

Encouraging economic signs continue to surface in North America, and as they do the nature of the investing debate is shifting.

Just a few months ago, the greatest fear in the global economy was a financial sector collapse and an accompanying depression. Today, however, with governments having injected huge sums of money into their economies, more and more top strategists seem most worried about something else: inflation.

It may seem like jumping the gun, given that both Canada and the U.S. have been experiencing deflation in recent months. But the threat is serious. For investors, that raises two key questions: Does inflation mean troubled times for stocks? And how can you position your portfolio to deal with an inflationary climate?

When it comes to the first question, many say high-inflation periods are indeed trouble for stocks. As inflation rises, governments will raise interest rates, the theory goes, and investors will flee stocks and head to Treasury bills.

The reality is much more complex. While history has shown that the stock-fleeing scenario can happen, it doesn't always. In 1975, when U.S. inflation averaged 9.2 per cent, the S&P 500 surged about 30 per cent while 10-year U.S. Treasury bills averaged an 8-per-cent yield. And in 1980, when inflation averaged 13.6 per cent - the highest annual reading of the past 60-plus years - the S&P gained almost 30 per cent, while 10-year T-bills yielded an average of 11.4 per cent throughout the year.

The Big Picture

Over the longer term, some of history's top strategists actually say that inflation is a big reason to buy stocks - not to avoid them. Foremost among them is Warren Buffett. His inflation research goes way back. In 1977 - just before the U.S. was about to enter into one of the worst inflationary climates in history - he wrote a column for Fortune magazine explaining how inflation hurts both stocks and bonds. But, he said, "stocks are probably still the best of all the poor alternatives in an era of inflation - at least they are if you buy in at appropriate prices." Thirty years later, Mr. Buffett still seems to believe that. Back in October, he urged investors to buy U.S. stocks, in part because he believed the government's response to the financial crisis would lead to serious inflation.

Why keep your long-term focus on stocks if inflation is coming? For starters, they have an overall advantage over fixed-income investments because of the equity risk premium - the notion that stocks return more than fixed income investments over the long haul because investors demand greater returns for taking on greater short-term volatility.

Just as importantly, when you factor in inflation, that advantage becomes even greater. When inflation hits, stocks can draw on increasing earnings streams as companies raise prices and increase profits to keep up with inflation. Most bonds and bills can't do that.

And when inflation is factored in, the equity risk premium becomes crucial: Fixed-income investments, because their nominal yields are usually lower than nominal stock returns to begin with, have a much bigger percentage of returns eaten away by inflation. Evidence of this can be found in the writings of another of the gurus I follow, David Dreman. In his book Contrarian Investment Strategies , Mr. Dreman noted that from 1946 to 1996, compound returns after inflation for stocks were better than those of bonds 84 per cent of the time if your holding period was five years. Stocks also outperformed T-bills in 82 per cent of those five-year periods. Using 10-year periods, stocks beat bonds 94 per cent of the time and T-bills 86 per cent of the time. When you look at 20-year holding periods, stocks beat both bonds and T-bills 100 per cent of the time.

Buffett-Style Stock Picks

Now, if you knew if and when major inflation was going to set in and how long it would last, you might - and, I stress, might - be able to make some short-term profits by jumping back and forth between stocks and fixed-income investments. But no one - myself included - knows those factors in advance, which is why I'm sticking with stocks.

With this in mind, I've tapped my Buffett-based quantitative strategy - up more than 33 per cent this year - to identify some current values in different areas. Mr. Buffett has said that the best protections against inflation are good earnings power (whatever the currency), having an excellent business (regardless of the industry) and the need for minimal capital investment.

My Buffett-based approach targets stocks that have boosted earnings per share in at least nine of the past 10 years, have 10-year average returns on equity of at least 15 per cent and have positive free cash flows, all of which align with Mr. Buffett's inflation-protection advice. My model is quite stringent, and currently gives 100 per cent scores to less than a dozen stocks in the market. Among its favourites: Calgary-based Imperial Oil Ltd. , consumer goods giant Colgate-Palmolive Co. and China's biggest cellular service provider, China Mobile .

 

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