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The past year has been tumultuous for the economy, mostly due to the pandemic. This is most apparent with inflation, which hit its highest point this August, resulting from supply-chain disruptions and unquenched demand. Spending power drops, diminishing hard-earned gains within clients’ portfolios.
However, investors should not be intimidated by high inflation rates. You can invest intelligently and maximize profits during challenging periods. By understanding the characteristics of high-quality companies and industries, investors can put themselves in a position of power rather than vulnerability. Furthermore, investors who focus on diversifying their assets among high-quality companies and industries will maximize returns, even during inflationary periods.
Regular versus inflation investing
Investing during inflation does not need to be avoided, so long as it is thoroughly understood. You must know what your investment goals are before you choose to take on investing during periods of high inflation. You shouldn't undermine those goals or put your portfolio at risk for minimal gains.
Inflation increases costs and decreases the value of the dollar, so this will affect investments in different ways. When inflation has been ongoing for a lengthy period, the Federal Reserve is likely to increase interest rates, which will affect how companies perform during these periods.
For example, real estate investments tend to do well, as properties will retain value and rental income can increase. Focusing on high-quality companies and industries through inflation will allow you to preserve your portfolio and potentially take advantage of unexpected returns when performed intentionally.
The characteristics of companies to invest in during inflation
Start with companies that have a strong business model and market presence. This includes companies with large profit margins, pricing power (to pass price increases on to consumers) and strong operating cash flow growth. These companies will be able to raise prices and still have consumers purchase their goods, keep costs low and continue to manufacture needed goods. Some examples include Apple (AAPL) or Costco (COST), both of which have enough strength to withstand high inflation through high consumer demand, strong pricing power and strong operating cash flows.
A low-levered balance sheet is another key characteristic of companies that are more likely to be inflation-proof. These companies often have strong cash flow, as well as substantial cash on hand with little debt, which tends to occur with more established companies. Startups, on the other hand, are usually highly levered. Often strapped for cash, they are incurring high amounts of debt in an attempt to grow or maintain their businesses. Moreover, they often don't have the customer loyalty to pass on price increases. Large, established tech companies, such as Google (GOOGL), are good examples of companies that have low-levered balance sheets.
The final characteristic of target investment companies is those with minimal assets. Per Warren Buffett, capital-intensive businesses are not good during inflation due to lower margins and the continuous need for reinvestment. With lower maintenance expenditures, these businesses still have enough cash to sustain the business and even grow through inflation, as long as they don't spend gratuitously.
While these characteristics highlight businesses that are good inflation hedges, there are multiple ways to evaluate companies. Additionally, certain industries, such as software, tend to be made up of companies that are adherent to the above characteristics, making them an excellent investment proposition.
Key characteristics within the software industry
The software industry includes some of the most promising investments during inflation. Software companies do not require the same type of expenditures as those with extensive physical assets. For the most part, they do not work with inflationary commodities as a fundamental part of their business, meaning their maintenance expenditures are less expensive.
Likewise, software companies may deal with inflation on wage and personnel costs, but they have the power to pass this on to customers through price increases. Software margins are already large, but more importantly, their value proposition is such that customers will stay loyal even with price increases.
A good example of a company with highly loyal customers who will absorb price increases is Disney (DIS). Thanks to the massive demand for and successes of its streaming services in both Disney+ and ESPN+, it deployed price increases earlier this year. This improves its cash flows, enabling it to persistently invest in growth, which is key to its positioning. More importantly, its customers are still willing to pay, thanks to the popularity of the services.
Moving forward
There is no silver bullet when it comes to investing during high inflation periods. However, seeking certain characteristics and industries helps to identify those companies that are better equipped to perform. Fundamentally, investors should be cognizant of the impacts of inflation on the economy, retain a diversified portfolio, and rebalance their investments according to the above principles to manifest a higher likelihood of success.
Bryan Lee is the chief investment officer at Blue Zone Wealth Advisors. Blue Zone Wealth Advisors is a wealth and investment management firm serving families and individuals in Southern California and across the United States. Headquartered in West Los Angeles, the Blue Zone team combines the intelligence of various financial disciplines under one roof to offer family office services to their clients.
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
