Most fund managers, if you asked them in private, would likely concede that buying a 30 year bond with a yield that is less than inflation is not an ideal long term investing strategy. Yet the current price of bonds suggests the actions of the majority of investors runs counter to this. You see, it is the actions of investors, not the sound bites they (and the talking heads on TV) espouse, that are important to take note of. Bond prices the world over are more or less at record highs. Never before in history have bonds been priced so well for deflation (except for the Great Depression).
It is important to remember that those in power at the Fed are all too aware of what prematurely restricting the money supply can do, as the Great Depression demonstrated. The unprecedented stimulus measures so far have been evidence of this.
Since 2008 there has been some $3-$5 trillion additional dollars invested in bonds, depending on which numbers you read. This is on top of the already enormous sum that was in Treasuries prior to 2008. If / when inflation does start to arise, what will happen to the trillions and trillions of new dollars sitting in treasuries? Remember, the worst enemy of fixed interest is inflation–it destroys returns. It may well be that the fear of deflation would evaporate and be replaced by a very real possibility of increasing inflation.
As an investor it is important for me to ask the question, “Ok, where will the money flow then?” One likely recipient for the unprecedented levels of capital is high quality US companies that have a proven ability to produce earnings that outperform inflation. It is important to understand the structural ramifications of the money printing / fear of deflation of the last 5 years. It has lead to the bond market swelling in size and the number of shares outstanding in big companies to significantly shrink. Buy-backs by major companies have been strong since 2008.
With companies producing record earnings and reluctant to push cash to work, they have embarked on enormous buy backs. In some cases (such as ExxonMobil) nearly 20% fewer shares are available now than just a few years ago.
What happens when record amounts of money move out of treasuries and begin chasing smaller availabilities of quality shares?
Rapid price appreciation, and a big bull market!
My 3 favorite picks to sit patiently with and ride the wave of money flowing out of treasuries are:
Exxon Mobil Corporation (NYSE:XOM) – The world’s largest company and arguably one of the world’s most efficient managers of capital. Some of its figures include a 26% return on equity, a healthy dividend of 2.6%, forward PE of just 10, and virtually no debt.
I believe Exxon Mobil Corporation (NYSE:XOM) is positioned to be the recipient of large amounts of capital, chasing an inflation protected asset.
Being in the oil and gas industry, Exxon Mobil Corporation (NYSE:XOM) has the ability to profit from inflation. Increases in energy prices can assist in pricing its assets favorably. The value of projects increases as the dollar per barrel of oil extracted raises, whilst costs such as labor may not rise as much. Consider that the cost of labor may increase with inflationary pressure a couple of percent–yet the price of oil could well jump by 10%-15%.
Yamana Gold Inc. (USA) (NYSE:AUY) is my next favorite pick – for reasons similar to those with ExxonMobil. Yamana Gold has the capacity to raise profits in real terms even in an inflationary environment. In addition to this, their core product becomes more sought after when inflation does present itself.
With reasonable financial metrics, including a forward PE of just 10 and very little debt, I don’t believe Yamana to be overvalued. Currently the 5 year forward PEG Ratio is 1.28, indicating slightly overvalued status. However, if inflation is to accelerate, the PEG ratio would likely shrink rather quickly as the price of gold escalates.
Yamana Gold presents a great opportunity to position myself for an inflation-driven bull market. Just with ExxonMobil, Yamana Gold is in the enviable position of being able to rapidly expand with inflation. With inflation increasing, gold prices appreciate, which can mean ‘fringe’ projects that were marginal can quite quickly become viable and profitable with higher gold prices.
Merck & Co., Inc. (NYSE:MRK) is my next favorite stock for an inflation-driven bull market. The big pharma company has serious clout when it comes to commanding market positioning and competitive advantages. Combined with a divided of 4%, it provides a larger income stream than treasuries, yet it is arguably safer. Merck derives its income from the sale of pharmaceuticals–hardly an industry that is about to disappear given the chronically ill health of the US population.
Compared to bonds, which are virtually priced to perfection, Merck & Co., Inc. (NYSE:MRK) seems quite cheap given the relative predictability of its earnings and dividends. With a recent pull back from $48, now at $42, it might well be a good value buy. Even just returning to $48 would be a return of some 14%. Add the 4% dividend, and this could easily be an 18% return in the next 12 months.
Whilst 18% in the next 12 month might well be nice, it is the next 3-5 years that is of more interest to me. I believe that investing in these stocks might help investors profit from an inflation-driven bull run.
Will these stocks take off tomorrow and produce excellent returns? I have no idea, but I do believe that inflation will become the theme in the medium to long term, and with that capital will flow accordingly. I feel that these 3 stocks provide an opportunity to benefit from this structural market shift.
I may be early, but I am happy to wait!
The article Invest in these Companies During an Inflation Bull Market originally appeared on Fool.com and is written by Jarrod Bailey.
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