An explainer for beginners on what types of stocks typically fare well during periods of inflation – and which potential investments on the ASX to have a look at that might fit the bill.
Note that this article refers to inflationary periods in which central banks don’t frantically rush to raise interest rates faster than anyone previously thought, and crush overall market sentiment.
It’s a term that’s begun to strike fear into the hearts of investors’ minds over the past couple of years since the global pandemic hit. No, not “Coronavirus”, although that’s one we’re all obviously tired of at this point as well.
That word is “inflation” – a beast that’s reared its head extremely rapidly, as economies worldwide decided to turn the money printers on full-bore and crank out massive amounts of stimulus.
It’s left many confused as to what to do with the money in their bank account, given that that same money is having its value eroded more and more each day it just sits there.
Why? In the most simple terms: during periods of inflation, cash is seen as the worst place to be asset-wise, as inflation by its nature eats away at the value of cash.
It honestly kind of sucks for all of us trying to get ahead, as the effects of inflation on your savings almost forces you to have money in the markets (or alternative investments).
This means taking on additional risk in what is already a pretty risky & shaky economy globally since the pandemic hit.
Most times, this would make it a simple decision to throw that cash into the stock market; unfortunately, at time of writing at the beginning of 2022, we’re in one of the frothiest periods in stock market history in terms of company valuations.
This makes finding solid companies that perform well during inflation and aren’t overpriced even more difficult; even just one of these variables is hard enough in itself.
The good news is that stocks/shares/equities/whatever you prefer to call them in your part of the globe typically outperform during inflation. The bad news is only certain types of stocks and their overlying businesses usually hold up better than others, if history is anything to go by.
For us Aussies looking to invest locally, the choices become even slimmer. So what should you invest in if you think inflation is going to be here for a while?
Good ol’ Wazza B – the widely-accepted GOAT of investing, Warren Buffet – famously set out two main criteria he recommends for types of companies to look for when inflation kicks in.
These are companies that have:
- An ability to increase prices rather easily without fear of significant loss of either market share or unit volume, and;
- An ability to accommodate large dollar volume increases in business with only minor additional investment of capital
There’s two parts to this, so let’s look at each separately, and how they are represented on the Aussie market.
“An ability to increase prices rather easily without fear of significant loss of either market share or unit volume.”
In other words: stuff people have no real choice, other than to have to buy.
The whimsical tech of the future that is not yet a revenue generator, or the speccy miner that needs funding to continue drilling their holes, or fashion/luxury and ‘consumer discretionary’ retailers that sell non-essential items & are hit by increasingly pricy supply chain issues… do not fit the bill in this case.
It’s instead many of those boring, essential companies – that have ‘inelastic demand’ – and are able to increase their price subtly that have typically been the winners in inflationary scenarios.
They’re able to pass through their higher costs of input onto the consumer and perhaps even improve their profit margins.
Of course, it’s not a blanket rule/guaranteed win as it will also still largely come down to the activities of the individual company (and market sentiment around them) itself.
Some of the key categories of stocks that fit this mould include:
Energy Stocks
It doesn’t take a genius to see that energy prices – from your monthly power bill, to filling the petrol tank up at the local servo – have had a real impact on actual wallets over the past year or so.
Oil prices have soared globally, as supply chain issues and a general lack of power availability have hit many countries in the rush to transition to renewables. Coal has also seen renewed surge in demand, despite its recent overall ‘black sheep’ reputation.
The energy sector is thus in a bit of a weird place for investors at the moment, as basic supply/demand needs battle against growing ESG (ethical) sentiment, to make what might normally be a fairly no-brainer inflation-based investment decision a little bit more uncertain.
Is the surging raw price of energy costs/oil/gas/coal temporarily strong enough to counter this global ‘ethical/green’ push? It might be – at least in the short term – if inflation levels hold.
Note this doesn’t include exploration companies that are yet hoping to find a resource even though their share prices might get caught up in the sentiment wave by association.
By the time they land a hit & progress to production, the inflationary period may have long passed.
Ways to get exposure on the ASX:
ASX ETFs: ASX:FUEL – an ETF provided by BetaShares, consisting of some of the largest global energy stocks. Holdings include a mix of companies throughout the oil & gas supply chain; comes with a 0.57% management fee.
Have a look at the level of correlation between this ETF and the level of reported inflation in the US over the past year; it’s a fairly strong one:
FUEL ETF share price performance:
ASX Companies to take a look at: WDS, STO, NHC, KAR, WHC
Consumer Staples Stocks
Your weekly shopping trip at the local supermarket has and will likely see knock-on effects from inflation as well, with the big grocery chains & various others who deal with necessary items bumping up prices for everyday food and essentials.
While major logistical issues and increased costs of freight are core issues with these companies’ supply chains, they’re not the only ones who have to end up footing the bill. The big Aussie supermarket chains in particular have the leverage to push their suppliers on one side, and the wallets of consumers on the other.
As the ‘end point’ and the last link in the inflationary chain before these products get to consumers, they’re passing on several steps-worth of price increases.
This results in people having no real choice but to accept the increased prices of their token bread, milk, veggies and everything else required to, you know… exist.
Yes, they’re one of the most “boring” categories mostly consisting of companies with massive market caps and little chance of rapid growth, but any kind of potential gain can still be a good one when inflation is running rampant.
The only issue at time of writing however, is that – in Australia, at least – the ongoing effects of Covid-19 & its restrictions has been having a particularly impactful effect on staffing and supply chain for the Aussie supermarkets.
This has caused their share prices to take a hit independent of external inflationary factors.
Ways to get exposure on the ASX:
ASX ETFs: ASX:IXI – an ETF provided by BlackRock’s iShares. Containing some of the biggest supermarkets and consumer staples products producers from across the globe, it’s a way to gain access to a diverse basket of these companies in return for a 0.46% management fee. A very low-volume ETF however, so liquidity can be an issue.
ASX Companies to take a look at: WOW, COL, MTS, ELD
Commodities Stocks
If there’s one thing Australia does well sector-wise, it’s raw materials & commodities, so there’s plenty of choice on our market in this department.
Research by Vanguard found that over the last ~10 years, commodities have shown a strong performance correlation with ‘unexpected’ inflation; when inflation rose 1%, commodities rose from 7 to 9%.
We covered energy stocks above specifically, but basically any raw/refined item that can be traded can be considered a ‘commodity’. Gold, aluminum, soybeans, cattle, iron ore, rapeseed (yes, that is an actual name of a traded commodity) and more are all popular, and the ASX is obviously rich with those of the ‘hard’ mineral variety in particular.
In the past, gold has always been seen as the typical ‘inflation hedge’ commodity, however in the past couple of years the world has seen some unusual sentiment there in which this seems to be changing.
“Alternative currencies” such as crypto have popped up designed to serve as an alternative to gold, and most of the Aussie gold miner companies have underperformed as the spot price of gold has either declined or flopped around going nowhere in particular ever since the start of 2021.
Whether this trend will sustain moving forward with additional rate rises still looming remains to be seen; gold may still very well finally break out of its slump.
Recently, many economic ‘experts’ have predicted that the 2020’s will be a decade with a “commodity supercycle”, mostly due to the switch to a ‘green’ world and the push towards electrification.
We’ve already seen materials such as lithium go on ridiculous price runs, while others such as nickel, copper, tin, rhodium and more have seen big upticks as well (prior to fears of the global economy slowing as interest rates rise rapidly).
There are nearly countless ASX businesses that deal with commodities in some form, with investors able to take their pick on which specific commodity/company combo takes their fancy.
This includes numerous miners that already produce many of the above and are highly profitable; with the rising prices of their key materials only likely to make them even moreso.
Ways to get exposure on the ASX:
ASX ETFs: resource-sector ETFs on the ASX provided by both BetaShares (ASX:QRE) and VanEck (ASX:MVR) provide easy access to a diverse mix of the big-wig Australian resource commodity stocks, with a mix of ‘hard’ and ‘soft’ commodities covered by their underlying businesses.
ASX Companies to take a look at: BHP, RIO, MIN, OZL, IGO, FMG… and countless other profitable ASX miners producing in-demand commodities.
Real Estate/REITs
You don’t necessarily need to actually buy (or already own) physical property directly in order to make extra coin from Australia’s seemingly ever-booming property market.
Real Estate Investment Trusts (REITs) – a company that typically owns real estate of various classes that produces income, such as rent – are a proxy way to invest that naturally scale quite well with inflation.
They tend to follow a similar pattern to consumer staples where incremental increases in rental income can be rolled out, and given the inherent need for housing or warehouse space, the tenants have no choice but to accept the increase.
This is in addition to the inherent growth in the value of the properties the REITs own – plus the fact that many of them pay pretty chunky dividends as well.
There are over 40 different REITs on the ASX each with their own different property portfolio profile breakdown, ranging from offices, to convenience retail stores, to hotels, to warehouses/storage… and yes, even residential property.
Thus if you feel a little ‘icky’ ethically about the concept of investing in housing, there’s plenty of opportunity for exposure to (non-residential) real estate of different classes on the Aussie exchange to pick instead.
Ways to get exposure on the ASX:
ASX ETFs: ASX:VAP – Vanguard Australia’s Australian Properties ETF is an ETF containing multiple Aussie REITs within; VanEck also have one under the ticker code MVA.
ASX Companies to take a look at: BWF, GMG, ARF, RFF
Now let’s look at the second Buffet-y criteria that helps companies resist the effects of inflation:
“An ability to accommodate large dollar volume increases in business with only minor additional investment of capital.”
Essentially: companies that can scale up operations, without having to fork out a ton more cash to do so.
This one’s a little harder, especially given that some of the businesses on the market (and the ASX in particular) that best fit this criteria at the moment have sky-high valuations.
Sectors that might fall under this criteria include:
(Profitable) Tech Company Stocks
They’re often immediately perceived as some of the worst stocks to hold when inflation rumblings start, however that blanket rule shouldn’t really apply to those tech companies that are actually turning a profit (they do exist, although they’re rare).
That’s because most kinds of tech and software services-style businesses are still some of the best when comes to scalability.
For most of these companies, scaling up simply means adding extra salaries, plopping a worker in front of a computer terminal, or perhaps increasing data centre bandwidth & cloud storage. Many also typically have good margins built-in to their business models.
Unfortunately company-wise (especially on the ASX), it’s slim pickings – for a couple of reasons.
The first is that most of the tech companies on our exchange are not profitable AND hugely overpriced vs. their actual earnings, even with the extra ‘buffer’ that high-growth tech stocks are typically granted for their valuations.
The second is that many tech companies in the growth phase operate on a steady diet of massive debt; and when inflation is high central banks like to ramp up interest rates to keep a lid on it.
This then screws over these tech companies in particular, making the costs of borrowing more expensive.
Lastly, the ability to up tech service prices without receiving a backlash/losing customers again typically only applies to essential tech companies that are crucially important to their users.
So if you’re going the tech route – especially in Australia – you might want to keep an eye out on those handful of technology companies that have been more careful with their balance sheets. Or alternatively, resign yourself to look for a way to invest in select companies from overseas for a greater range of options.
Ways to get exposure on the ASX:
ASX ETFs: to be honest, there aren’t really any Australian domiciled ETFs that would fit the bill. There’s ASX:FANG from ETF Securities, and given its name you’d think it would just be the big, profitable US tech giants that make up its initials (Facebook, Apple, Netflix, Google) which are all profitable & fairly scalable.
However, while they’re certainly contained within, its largest holding is Tesla – which is counter to the whole principle we’ve discussed here – and there are plenty of others with iffy balance sheets lumped in as well.
ASX Companies to take a look at: WTC, DTL, CPU, RKN, PTB
Insurance Company Stocks
While insurance stocks may benefit during inflationary periods, it’s not necessarily in the same way as other companies do.
There are two factors which can have a knock-on effect to insurers related to inflation.
Times of low interest rates and plenty of general money-printing encourage more consumer spending, including on cars, boats, motorhomes and houses, which means more insurance policies that can be sold for each of these assets.
As insurance companies also profit from investing the funds that they take in/underwrite, on the other side, rising rates can help them earn a greater return on this invested capital.
They’re typically seen as fairly ‘defensive’ stocks as a result, and are able to increase their premiums on the likes of health insurance by a few percentage points here and there without typically alienating too many customers.
Each insurance company has a different model, and as a result they can land on either side of the inflation-reactionary-measures impact scale.
Ways to get exposure on the ASX:
ASX ETFs: The bigger insurance companies are contained within larger Australian index tracking ETFs such as A200 and VAS, but otherwise there’s no sector-specific ETF for insurance.
ASX Companies to take a look at: QBE, NHF, SDF, AUB
Banks Stocks
Bank stocks typically walk a fine line when it comes to inflation.
Similar to insurance companies, too much or too little of both consumer confidence and rapid interest rate rises can cause their delicately-balanced ship to capsize.
Bank stocks tend to do well with a certain degree of inflation that causes regulators to take action and increase rates, which the banks then in turn increase and pass onto customers. If the economy is strong and people are confident while this level of inflation is taking place, then that’s an ideal situation.
A gradual rise of a smaller amount of basis points staggered throughout the year is manageable; it’s when the rate rises come faster than expected and crush consumer confidence to spend or take out loans that the shit can start hitting the fan.
The worst-case scenario would be if inflation spiralled out of control, rates rise far faster than anticipated and people (or businesses) simply stop spending, or can’t afford to pay the banks back the money owed. As 2022 has rolled on, this scenario is unfortunately starting to become more of a reality.
Thus, whether or not you think Aussie banks will actually be a good inflation bet (this time) will largely depend on how much faith you have in the world’s central banks to be cautious with their handling of this delicate monetary environment moving forward.
Ways to get exposure on the ASX:
ASX ETFs: ASX:MVB by VanEck is an ETF that contains all seven of Australia’s largest banks by market cap, and charges a 0.28% management fee for the privilege; BetaShares meanwhile offer a global banks ETF in ASX:BNKS containing a more global diverse mix of banking giants with a fee of 0.57%.
ASX Companies to take a look at: MQG, WBC, ANZ
Of course, with endless external factors all taking place at the same time as inflation, there’s no guarantee these sectors of companies will hold up to their historical trend.
Things such as pandemics, global political tensions, individual company performance, and general media doom and gloom can still tank stock prices regardless of other macro factors working in their favour.
Should those other extraneous issues subside however, there’s plenty of investment opportunity to look at within the above to attempt to fight off the inflation demon.
