INFLATION BEATING STOCKS

Inflation Beating Stocks

 

Introduction

As the market spectre of rising inflation has come back to the fore, we look at what it is and which sectors can offer investors a shelter from it. The inflationary concerns rearing up at the moment are on a global level and fuelled by several catalysts including, a hangover from the lack of economic activity during the pandemic, China’s current lockdowns and impact on supply chains, and the conflict in the Ukraine.

If rapid inflation does set in, some product and service sectors can pass inflation on to their customers a bit easier than others  in the form of a price increase. A lot of utilities can do so, as their pricing agreements with regulators tie price increases to the inflation rate. Vice stocks also offer inflationary covers largely due to the fact their consumers will continue to consume regardless of prices. This includes tobacco, gambling and alcohol stocks. Tobacco and alcohol companies have a lot of pricing power because consumers crave their products.

Luxury brand’s also offer a form of defence against inflation as the purchasing power of the luxury brand consumer doesn’t usually get dented quite as much as the spending power of the average man on the street. However you will note we don’t highlight any luxury brands in the report and that’s because whilst they can offer a hedge against inflation, they also have large exposure to China and the Asian markets and so with a lot of Covid, supply chain and growth concerns in China they may not be quite as defensive as they had been in the past.

Commodity stocks can also offer a shelter as the price of the underlying commodities tend to increase; this is even more prominent in the recent markets as talk of the beginning of a commodities super cycle is being banded around (but that’s more of a topic for another report).

The final sector that can offer a shelter is defence stocks, whilst not the top of everyone’s list the contracts they win are with government bodies so avoid the knock on from consumer’s drop in buying power. The defence sector has also been under pressure for years especially in the UK as the government spending on defence has been weak for years, of course in the current climate this is changing.

What is Inflation, and what does it mean.

Inflation is the decline of purchasing power of a defined currency over a set period. This can be reflected in the increase of an average price of a basket of selected goods and services in an economy over a defined period. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did previously.

The basket (more commonly known as price indexes) generally includes the following mix:- commodities like metal and fuel, food grains, utilities, and services like healthcare and entertainment. Inflation aims to measure the overall impact of price changes for a diversified set of products and services and allows for a single value representation of the increase in the price level of goods and services in an economy over a period of time.

Types of Price Indexes

The two key price indexes are The Consumer Price Index and the Wholesale price index:-

The Consumer Price Index

The CPI is a measure that examines the weighted average of prices of a basket of goods and services which are of primary consumer needs. They include transportation, food, and medical care. CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. The prices in consideration are the retail prices of each item, as available for purchase by the individual citizens. Changes in the CPI are used to assess price changes associated with the cost of living, making it one of the most frequently used statistics for identifying periods of inflation or deflation.

The Wholesale Price Index

The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level at the wholesale level. While WPI items vary from one country to other, they mostly include items at the producer or wholesale level. For example, it includes cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing. Although many countries and organizations use WPI, many other countries use a similar variant called the producer price index (PPI).

Impact on Cash and Bonds

Whichever way you look at it,  inflation is not good for cash. Money kept under the mattress will find its value eroded as prices rise and with it near impossible to find a savings account offering an inflation beating (or even equalling) interest rate, money held in a bank account could and probably will suffer. Inflation is not really that positive for bonds either. If prices rise at a rate greater than the interest you earn on a bond, you’ll find the value of your fixed income fall in real terms. Consider a five-year bond paying 2% nominal interest. If inflation rises to 2.5% for those five years, your bond won’t be able to keep up.

Causes of Inflation

An increase in the supply of money is one of the key root causes of inflation, though this can play out through different mechanisms in the underlying economy. Money supply can be increased by the monetary authorities either by printing and giving away more money to the individuals, by legally devaluing (reducing the value of) the legal tender currency, more (most commonly) by loaning new money into existence as reserve account credits through the banking system by purchasing government bonds from banks on the secondary market (Quantitive easing). In all instances of money supply increase, the money loses its purchasing power. The mechanisms of how this drives inflation can be classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.

 

Types of Inflation

Demand-Pull Effect

Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy's production capacity. This increases demand and leads to price rises. With more money available to individuals, positive consumer sentiment leads to higher spending, and this increased demand pulls prices higher. It creates a demand-supply gap with higher demand and less flexible supply, which results in higher prices.

Cost-Push Effect

Cost-push inflation is a result of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channelled into commodity or other asset markets and especially when this is accompanied by a negative economic shock to the supply of key commodity, costs for all kind of intermediate goods rise. These developments lead to higher cost for the finished product or service and work their way into rising consumer prices. For instance, when an expansion of the money supply creates a speculative boom in oil prices the cost of energy of all sorts of uses can rise and contribute rising consumer prices, which is reflected in various measures of inflation.

Built-In Inflation

Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers and others come to expect that they will continue to rise in the future at a similar rate and demand more costs/wages to maintain their standard of living. Their increased wages result in higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.

 

Stocks to Watch

British American Tobacco

British American Tobacco plc is a British multi-national company that manufactures and sells cigarettes, tobacco and other nicotine products. The company was established in 1902 with headquarters in London. They have operations in around 180 countries, and its cigarette brands include Dunhill, Kent, Lucky Strike, Pall Mall and Rothmans. Its new age brands also include Vype, Vuse and Glo. Cigarette smoking itself has of course been in decline for years, but there are still an estimated 1.1bn smokers worldwide. Europe has 112mn of them. Cigarette demand is what economists call "inelastic," meaning smokers aren't price sensitive.

Despite a constant barrage of regulation changes and a traditional industry in decline you’d be forgiven for thinking the long-term outlook for tobacco companies is bleak! The reality is the tobacco sector still has a lot going for it and are still making inroads into new world vaping products. The sector has always been appealing with the income investors as well due to the large yields on offer. Recent figures have highlighted BAT’s is still in rude health despite the backdrop.

Key Fundamentals

Valuation	Balance Sheet	Income Statement
Market Capitalization74.972B	Current Ratio (MRQ)0.8457	Basic EPS (FY)2.9685
Enterprise Value/EBITDA (TTM)8.2470	Debt to Equity Ratio (MRQ)0.5816	Basic EPS (TTM)2.9676
Total Shares Outstanding (MRQ)2.27B	Net Debt (MRQ)35.933B	EPS Diluted (FY)2.9556
Number of Shareholders108.467K	Total Debt (MRQ)39.198B	Net Income (FY)6.789B
Price to Earnings Ratio (TTM)11.1881	Total Assets (MRQ)137.365B	EBITDA (TTM)11.608B
Price to Revenue Ratio (TTM)2.9585	Dividends	Gross Profit (FY)17.819B
Price to Book (FY)1.1277	Dividends Paid (FY)−4.904B	Last Year Revenue (FY)25.713B
Price to Sales (FY)2.9540	Dividend Yield Forward6.5870	Total Revenue (FY)25.713B
	Dividends per Share (FY)2.7225	Free Cash Flow (TTM)7.744B

BAE Systems 

BAE Systems plc is a British multinational arms, security, and aerospace company based in London. It is the largest defence contractor in Europe, and ranked the seventh largest in the world based on  2021 revenues. The company manufactures military aircraft, surface ships, submarines and radar systems. Its largest operations are in the UK and US, where BAE Systems Inc are one of the six largest suppliers to the US Department of Defence. Other major markets include Australia, Canada, India, Saudi Arabia, Turkey, Qatar, Oman and Sweden, where Saudi Arabia is regularly among its top three sources of revenue.

Defence companies are generally protected from inflation by contracts that allow them to pass on most cost increases to customers. Recently the UK Government decided to increase the defence budget over the next four years after years of reduced spending. With the end consumer for defence stocks being governments there is also very little chance of a drop in activity so again offering a shelter from inflation.

Key Fundamentals

Valuation	Balance Sheet	Income Statement
Market Capitalization23.443B	Current Ratio (MRQ)1.0140	Basic EPS (FY)0.5516
Enterprise Value/EBITDA (TTM)8.2318	Debt to Equity Ratio (MRQ)0.8289	Basic EPS (TTM)0.5516
Total Shares Outstanding (MRQ)3.156B	Net Debt (MRQ)3.245B	EPS Diluted (FY)0.5475
Number of Employees82K	Total Debt (MRQ)6.356B	Net Income (FY)1.758B
Number of Shareholders95.7K	Total Assets (MRQ)27.135B	EBITDA (TTM)2.498B
Price to Earnings Ratio (TTM)13.5938	Dividends	Gross Profit (FY)5.192B
Price to Revenue Ratio (TTM)1.2202	Dividends Paid (FY)−777M	Last Year Revenue (FY)19.521B
Price to Book (FY)3.1631	Dividend Yield Forward3.3655	Total Revenue (FY)19.521B
Price to Sales (FY)1.2242	Dividends per Share (FY)0.2510	Free Cash Flow (TTM)1.914B

Rio Tinto

Rio Tinto is an Anglo-Australian multinational and one of the world's largest metals and mining corporations. The company was founded in 1873, when a multinational consortium of investors purchased a mine complex on the Rio Tinto, in Huelva, Spain from the Spanish government. Rio’s focus is mineral extraction however operations do expand into the refining of certain minerals, particularly bauxite and iron ore. Rio Tinto is a dual-listed company traded on both the London Stock Exchange and the Australian Securities Exchange. Additionally, American Depositary Shares of Rio Tinto's British branch are traded on the New York Stock Exchange giving it listings on a total of 3 major stock exchanges.

Rio’s main commodities are aluminium, copper, diamonds, gold, iron ore, and uranium as well as industrial minerals borates, titanium dioxide and salt.

Mining Stocks are also seen as a good inflationary hedge. As inflation rises so does the cost for the minerals they mine. Miners’ profits are directly tied to the price at which they can sell the metals they dig up and as the prices increase so does the profits. Of course, some metals will perform better than others so its always worth looking at a diversified mining company rather than a mining company tied to just one commodity.

Key Fundamentals

Valuation	Balance Sheet	Income Statement
Market Capitalization85.984B	Current Ratio (MRQ)1.9349	Basic EPS (FY)9.4771
Enterprise Value/EBITDA (TTM)3.3630	Debt to Equity Ratio (MRQ)0.2391	Basic EPS (TTM)9.4620
Total Shares Outstanding (MRQ)1.619B	Net Debt (MRQ)−1.297B	EPS Diluted (FY)9.4160
Number of Employees49.345K	Total Debt (MRQ)9.99B	Net Income (FY)15.338B
Number of Shareholders35.102K	Total Assets (MRQ)75.969B	EBITDA (TTM)25.249B
Price to Earnings Ratio (TTM)5.4934	Dividends	Gross Profit (FY)22.547B
Price to Revenue Ratio (TTM)1.8235	Dividends Paid (FY)−11.166B	Last Year Revenue (FY)46.168B
Price to Book (FY)2.2002	Dividend Yield Forward11.1865	Total Revenue (FY)46.168B
Price to Sales (FY)1.8218	Dividends per Share (FY)5.7756	Free Cash Flow (TTM)13.981B

Diageo

Diageo is a British multi-national beverage alcohol company, with its headquarters in London. Diageo was formed in 1997 from the merger of Guinness Brewery and Grand Metropolitan. It now operates in more than 180 countries. It is a major distributor of spirits and the world's largest producer of Scotch whisky. Diageo has a primary listing on the London Stock Exchange and is a constituent of the FTSE 100 Index. It has a secondary listing on the New York Stock Exchange. Diageo posted decent results in January, with net sales up 15.8% to £8bn and strong organic growth, despite currency fluctuations. Organic net sales were up 20%, while reported operating profits rose 22.5% to £2.7bn.

The range of products is almost as large as the countries they operate in and include various types of drink.  Their portfolio includes most notably, the Scotch whisky brands , Johnnie Walker, Bell's, Black & White, Oban, Talisker, the leading vodka brand Smirnoff, the rum brand Captain Morgan. Their Liqueur brands include Baileys, Sheridan's and Pimm's.  Their Tequila brands Don Julio, DeLeón and Casamigos. They also own the leading gin brands of Gordon's, Tanqueray, Gilbey's and Aviation Gin and of course the beers include Guinness, Tusker, Harp Lager, Kilkenny, Senator, Meta Abo and Smithwick's.

Diageo also owns a 34% stake in the Moet Hennessy drinks division of French luxury goods company LVMH Moët Hennessy Louis Vuitton SE.

Key Fundamentals

Valuation	Balance Sheet	Income Statement
Market Capitalization85.157B	Current Ratio (MRQ)1.5224	Basic EPS (FY)1.1382
Enterprise Value/EBITDA (TTM)22.5183	Debt to Equity Ratio (MRQ)1.4872	Basic EPS (TTM)1.3048
Total Shares Outstanding (MRQ)2.319B	Net Debt (MRQ)12.031B	EPS Diluted (FY)1.1343
Number of Employees27.783K	Total Debt (MRQ)13.877B	Net Income (FY)2.66B
Price to Earnings Ratio (TTM)28.5694	Total Assets (MRQ)33.16B	EBITDA (TTM)4.683B
Price to Revenue Ratio (TTM)6.2882	Dividends	Gross Profit (FY)7.735B
Price to Book (FY)12.5793	Dividends Paid (FY)−1.646B	Last Year Revenue (FY)12.733B
Price to Sales (FY)6.8405	Dividend Yield Forward1.9911	Total Revenue (FY)12.733B
	Dividends per Share (FY)0.7255	Free Cash Flow (TTM)2.845B

Hedging Your Portfolio

If current market conditions are causing concerns for your portfolio, then please feel free to watch our video on shorting the market below. 

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