Be careful what you wish for, or, as they say, it might happen. For two decades and across the developed world, inflation was tiny; policymakers, economists and commentators said we needed higher inflation. So now we have got it, what can investors do?
According to Mohamed El-Erian, the former CEO and co-chief investment officer at PIMCO and all-round guru on investing, “investors should prepare for increased market volatility, elevated inflation and sustained supply-chain snarls.”
The jury is out on how long the crisis may last; inflation may only be transitory, supply-chain issues will probably ease, but labour shortages are likely to persist with the retirement of baby boomers.
Not all the advice floating around at the moment makes sense.
Some say buy property — but if interest rates rise significantly, that might not be such a good idea. Others say buy commodities— but commodity cycles turn, and while the oil price may indeed continue to rise for some time, its long-term prognosis might not be so good. Other commodities might be more attractive, however.
Others say avoid tech and growth stocks in general because when the markets value companies, they are meant to estimate future earnings and discount those future earnings to derive a net current value. If interest rates go up, then the discount on those future earnings increases. Thus, companies for whom the opportunity lies further into the future have a lower net current value.
A key factor to consider, which I think is often forgotten, is that in valuing assets, it is real interest rates that count. So, for example, say inflation increases to five per cent from the two per cent rate it has been at over recent years, but interest rates rise from 0.1 to two per cent; in real terms, interest rates will have fallen.
But diversification is essential, and these are uncertain times. So, an investor should consider having a higher proportion of stocks that provide higher earnings to market cap in the shorter term. Or, to put it another way, invest in more dividend stocks.
Not all dividend stocks are ideal — investors need confidence that dividends can be sustained.
It is worth considering good dividend-paying companies with strong balance sheets, a good history of dividend growth, a high ratio of profits to dividends, modest debts to assets and forecasted dividend growth. It will also help if their products are essential in tougher times such that they can increase prices in line with inflation.
Here are three companies I think are worth considering during a period of inflation. In each case, I am considering companies that are probably pretty good bets anyway but have just become even more attractive in current times.
Unilever (LON: ULVR)
First off, Unilever. I have long been a Unilever fan anyway but look at its track record. Here is a company that has been consistently increasing dividends for decades. You can look back five years, ten years or 40 years; the dividend story is one of strong growth.
The yield is around 3.7 per cent, not exactly scintillating, but this is a quality company, and quality costs money in the short term but is likely to pay handsome rewards longer term.
Its balance sheet is strong, and its product range is both diverse and largely made up of must-have products.
Rio Tinto (LON: RIO)
Rio Tinto had a tough third quarter and was forced to cut iron ore output — it’s a long-running tale and one in which the company has not covered itself in glory.
But commodities are strong, and Rio Tinto is also big in copper — which is likely to remain in high demand for the foreseeable future – and has a significant investment in aluminium.
Dividend growth over five years, ten years and twenty years has been impressive, and the dividend yield throughout 2021 has been a mouth-watering 13.91 per cent. Of course, that number is a little misleading; for one thing, dividend payments span two financial years and include special dividends; but even so, dividends are at tempting levels. As of the end of July, Rio Tinto had $10.2 billion in net cash, and net debt at the company has plummeted over the last half a decade.
Legal & General (LON: LGEN)
I covered Legal & General recently, but it is important to reiterate that this company pays out a good dividend (around six per cent), has a strong balance sheet and offers exposure to growth stock via its venture capital arm.