Ryan Modesto, CFA, is Managing Partner at 5i Research, a conflict-free investment research provider for retail investors offering research reports, model portfolios and investor Q&A. 5i Research provides content under an agreement with The Globe and Mail, which receives royalty compensation. Try it.
Inflation has been a concern that has long fallen off of many investors' radar.
With annual inflation well below 2 per cent for the most part since 2012 and generally below 3 per cent for the last 10 years, it is an investment risk that has not really posed a whole lot of problems to portfolios in recent memory.
All of this could change soon.
With a changing of the guard in the United States and potential implementation of some less traditional policies, inflation could soon rear its ugly head once again.
Unfortunately, the one thing that most investors look to hold during tough times (cash) may be one of the worst places for an investor to hide when inflation comes. So what is an investor to do?
Asset classes such as gold and real return or inflation-protected bonds are reasonable options, but stocks, in general, tend to be a good hedge against inflation.
From 1972 to 1984, a period when inflation rates grew from roughly 5 per cent up to as high as 12 per cent, Canadian stocks actually matched the rate of growth of inflation. While Canadians were certainly not gaining a whole lot in real terms (once you factor in the costs of inflation), they also did not lose out. Compare this to something like cash where a 10-per-cent rate of inflation means that the cash would actually purchase 10 per cent less goods.
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Not convinced with the ability of equities to outperform that of inflation (or the merits of investing in stocks in general)? Just look at a long-term chart of the TSX Composite.
So why do stocks make a good hedge against inflation?
In most cases, companies have some ability to pass the added costs of inflation on to the end customer. If prices of the products being sold are going up to offset the costs, a company can maintain margins and growth and still provide returns to the end investor.
But how do we find companies that are able to do this?
We think there are two ways this can be done effectively.
The first is to consider the industry, as some types of businesses will have more success at passing costs along. The other way to confirm a specific company in the right industry can pass inflation costs along is to look at dividend growth.
In general terms, if a company is growing the dividend at a consistent and steady rate, that company is also growing cash flows and/or earnings. More earnings mean that there is an ability to pay more dividends and growing earnings/dividends overlaid by an industry that can increase prices should be a strong indicator of whether a company can pass on inflation costs over time. With this in mind, we can look at some industries and companies that should have a knack for protecting investors from inflation.
Essential services
Take a moment to look around your house or outside.
What are some things that would be difficult to live without, are key to a functioning society, or at least would materially impact your current lifestyle? These are the companies that can be quite effective at passing on inflation costs. Industries such as telecom and financial services are a great place to start. These two industries can be particularly effective since they operate in an oligopoly-like environment. Put simply, if they increase costs, the customers do not really have many options for alternative providers that could compete on lower cost.
Over five years, BCE Inc, a provider of Internet and phone services, has grown the dividend by over 6 per cent annually. Bank of Nova Scotia has grown the dividend by just over 7 per cent over the same period. Both of these names are ones we hold in our model portfolios specifically for reasons such as dividend growth and an ability to pass along costs over time.
Another service worth considering is that of waste management. For better or worse, people create lots of garbage and it all needs to be moved and go somewhere. Companies, like Waste Connections Inc. and the aptly named Waste Management Inc., fit this niche perfectly. Waste Management dividend growth over five years has been over 3 per cent, right in the range one would want to offset inflation rates over long periods.
'Sin' stocks
While this niche may not cater to all investors, "sin" related stocks have an ability to grow with inflation.
If times are good, you may celebrate over a smoke or drink. If they are bad, you may commiserate over a smoke or a drink.
The point is, that in good times or bad, the customers of these products are likely willing to spend the money on the products being supplied. Wine company Andrew Peller Ltd. has more than beat inflation, returning roughly 75 per cent since we first reported on it back in August 2015, and the dividend has also proven to be a good offset with five-year annual dividend growth just shy of 6 per cent. Corby Spirit and Wine Ltd. has grown the dividend by just over 6 per cent. Altria Group Inc., a tobacco company, has grown its dividend by over 8 per cent in the same period.
Investor looking for a bit of a different twist on sin stocks may want to consider a vice in the form of gambling stocks. Casino operators, like Great Canadian Gaming Corp. and GameHost Inc., offer exposure to fairly stable businesses while also being regulated, making competition from new entrants difficult.
Consumer staples
Everyone needs to eat. Given that grocery companies already operate with thin margins, when prices go up, they really have no choice other than to pass the costs on to the consumer. It can be painful at the checkout for the customer. Purchases can be delayed or shifted, but over time these cost increases tend to work their way through to the end purchaser. While the dividend is low, Loblaw Companies Ltd. has a five-year dividend growth rate of 4 per cent, while higher-yielding North West Company Inc. has an annual growth rate in excess of 5 per cent.
Even though equities as an asset class can tend to provide a good hedge to inflation risks, an investor can find industries and investments within equities to help further protect them from inflation. It still looks like any material pick-up for inflation is further down the line. However, being ready for the unexpected never hurts, and neither does owning long-term dividend growers that offer a product or service you "need" whether you like it or not.
Readers can follow @5iresearchdotca on twitter to get timely updates on dividend initiations, increases and cuts in Canadian markets.
Please perform your own due diligence before making investment decisions.
In order to remain truly conflict-free, the writer and employees of 5i Research cannot take a position in individual Canadian equities.
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