The Silent Killer

Inflation is an insidious threat. Economic predictions are said to make weather forecasts look respectable -- but inflation is one you can count on.

The normal course of things is that money loses its worth over time -- the sordid result of government overspending -- and the endgame is a declining value in currencies, not relative to one another, but to goods and services. In the wake of S&P's negative outlook on "AAA" U.S. treasury debt, the odds of inflation have increased. An outright default is highly unlikely, because the dollar is the world's reserve currency and the US controls the printing presses. But if more money is printed than should be, it quickly loses its value. The result is inflation.

I explain to my finance students that inflation is like hypertension: a silent, symptomless killer. The investor who keeps their money in a savings account will never see inflation losses on the account statement. Over time, however, their cash will become less and less valuable until it buys half of what it used to. The easiest way to grow poor for the long run is to succumb to the ersatz safety of cash.

In order to beat inflation, money must be invested wisely. The best "traditional" protections against inflation are stocks, real estate and commodities. These three asset classes typically provide a "real return" above and beyond the historical inflation rate of 3% -- and tend to derive much of their increase in value from the same underlying dynamics that drive inflation itself. Bonds, CD's and money markets are the worst places to hide from inflation: their fixed interest rates and low returns can't keep up with the silent killer. Bonds protect against other risks, such as market risk and volatility, but they do nothing against inflation.

The latent creep of inflation is clear. The monetary and fiscal binge of the past few years has made inflation inevitable. As a result, all the obvious inflation hedges have been bid up to absurd levels; their prices have long ago baked in an inflationary scenario. Gold, TIPS and commodities of every stripe have reached prices too lofty relative to real value, thus lowering their future expected returns. In short, these inflation "plays" are bubbles ready to burst. We did own the gold mining stocks for clients (via the GDX etf) from December, 2008 to October, 2010, but we sold the positions as prices reached nosebleed levels. They're too dangerous to own now.

What then are the less obvious inflation hedges -- ones which have not yet priced in the conventional wisdom? A few are hidden in plain sight.

Stocks in general are good inflation protection. Stocks often reflexively sell off as inflation appears, especially if accompanied by steep interest hikes. But stocks are excellent inflationary hedges over time. Stocks are the ownership interest in companies -- companies which have the essential ability to raise both their prices and their dividends, powerful protection against money's loss of value. The average annual return during the four major inflationary periods of the past century (1914-19, 1945-47, 1949-51, 1965-81) is a surprising +12.1%. The inflation rate during those periods was +8.3%, reducing the "real return" to just +3.8%. Bonds, however, made only +3.1%, which delivered an annualized real loss of 9.0%, after inflation costs were netted out. There are certain stocks that are especially good (and less obvious) hedges against inflation, such as the those of companies with strong brands and potent pricing power -- companies such as consumer staples powerhouses Procter & Gamble, Colgate-Palmolive and Clorox.

Then there's one type of stock we'd like to highlight: stocks of companies that can actually make money as interest rates rise. These companies don't just profit from price increases but also from the Fed's sequential policy response of tighter money. What's more, their leverage to inflation is less understood by market participants. This complexity has kept buyers away, leaving their prices attractive.

Companies that Mint Money as Interest Rates Rise

These gems of the financial world are unusual. Their magic stems from the ability to invest "float," large sums of interest-free money that can be invested pending a future payout. The best examples are payroll processors and insurance companies. Among the payroll processors, both Automatic Data Processing (ADP) and Paychex (PAYX) are companies that have vast amount of available float that can be invested at higher rates as the Fed starts to tighten the screws. We own these stocks for clients.

Take PAYX as an example. This company holds float in the form of payroll money for clients deposited -- pending remittance to the taxing authorities. At last count, PAYX had over $3 billion dollars in this form of investable float. Unlike a bank, PAYX doesn't have to pay interest to the clients on these sums since it only holds the money for a month or so. The money is essentially "free." Since new payroll is always coming in as payroll taxes get paid, float remains at high levels. A disadvantage to this arrangement is that float must be invested in short-term commercial paper to match the low duration of the payroll obligations. At current record low interest rates, PAYX is earning less than 2% on its float. As rates rise, float can be reinvested at progressively higher rates. Small changes in yields can make a big difference in float income. Each additional dollar of float income drops directly to the bottom line since there's no cost to it.

To see this illustrated in graphic form, we can see how changing the float interest rate affects the present value of PAYX. In the Trefis chart here, you can see how the intrinsic value per share rises when short-term interest rates are adjusted upwards in tune with a highly inflationary scenario.

The payroll companies are one way to protect against inflation that remains beneath the radar screen. The other way is through consumer staples companies with pricing power. We continue to add exposure to these two categories across our client accounts.

DISCLOSURE: James Berman owns both PAYX & ADP personally and for clients. James Berman is also an investor in Trefis.