By Steve Dinnen
Inflation is upon us. It’s in our grocery cart. It’s on our restaurant tab. It’s in our airplane tickets. And it’s in our investment portfolio. Some companies can handle inflation well, while others perform poorly. Just as we can change our grocery buying habits a bit to blunt the impact of rising prices, we likewise can alter our investment portfolio to better glide it through an uncertain period of inflation.
One action you might consider is to avoid REITs and energy pipelines that pay hefty dividends and attract investors because of that.
“Dividend vehicles in rising rates get demolished,” said Kelly Flynn (pictured), founder and owner of Des Moines-based Prospective Value Partners. While there are no absolutes, higher-yielding stocks generally do not perform well in rising rate environments. Since they are “bond proxies,” higher rates make them relatively less attractive as investment vehicles.
On the other hand, Flynn said financials should do relatively well in a rising rate environment. “Banks’ [interest rate] margins will expand, insurers will benefit from higher yields in their sizable bond portfolios,” he said. (Insurers typically hold bonds to their maturity, which avoids the problem of selling an existing bond into a rising interest rate market.)
Flynn said that if we find ourselves in a sustained inflationary environment, companies with pricing power should outperform. Pricing power simply is the ability to raise prices without curbing sales. Flynn does not make any recommendations of what stocks have this clout, but in speaking with The Street, Ed Wolfe, of sell-side analyst Wolfe Research, ticked off a few that come from a wide variety of industries: drinks maker Constellation Brands, apparel company Ralph Lauren, medical device manufacturer Dexcom, and fast food giant McDonald’s. Companies that are “stuck in the middle” with rising input costs but limited ability to raise prices should underperform.
Value stocks perform better in high inflation periods and growth stocks perform better when inflation is low. Stocks tend to be more volatile when inflation is elevated.
Notwithstanding the above, Flynn said rising rates will be a headwind for the market as a whole. But overall he still favors stocks over bonds. Speaking of bonds for a moment–inflation is their worst enemy. That’s because inflation erodes the purchasing power of a bond’s future cash flows. Typically, bonds are fixed-rate investments. If inflation is increasing, the return on a bond is reduced in real terms, meaning adjusted for inflation.