Index funds won’t protect your wealth from inflation – here’s why

How to protect your portfolio from inflation?

One line that fund managers will come to you often is that you should invest in companies with “pricing power” – if a company can raise prices along with inflation, then what’s the problem? You are covered.

It’s a heartwarming idea. Unfortunately, it’s more complicated than that.

The two questions that really matter in valuing stocks

When you read the discussion about inflation and stocks, the term “pricing power” is often one of the first things that come up. The idea is that you invest in companies that can push their prices up according to inflation. This gives them resilience in the face of rising costs. It sounds logical – and it makes sense. However, that is not the whole story. Why not?

Duncan MacInnes of Ruffer has an interesting article on Citywire, in which he gives an excellent point on stocks and inflation, which I will paraphrase here.

If you really want to summarize, the course of a stock is dictated by the answer to two questions. The first question is: what do you think will be the company’s future profits? Owning shares in a company entitles you to a corresponding proportion of those future profits. So when you buy a stock, you get an idea of ​​what those future profits will add to.

This brings us to the second question. You know what you expect (approximately) from future income, but the next question is: what are you willing to pay for that income?

This forms the basis of the classic valuation ratio, the price / earnings (p / e) ratio. The p / e ratio simply takes the stock price and divides it by the earnings per share. So if the stock costs £ 20 and the earnings per share is £ 1, the p / e ratio is 20. The market is willing to pay £ 20 for every £ 1 of profit today.

And that’s where inflation has its real effect, notes MacInnes. Let’s say you have a business with strong pricing power; it can ignore inflation quite cheerfully, so let’s say its profits remain static in real terms (that is, they take inflation into account). The problem is, during times of inflation, investors as a group become less willing to pay that much for a given income level. In other words, the p / ea ratio tends to go down.

So today, investors might be willing to pay £ 20 for £ 1 in earnings. But as inflation rises and political and economic risks increase with it, they worry. At the end of the year, say, the amount they’re willing to pay drops to £ 10. As a result, the share price drops by half even though earnings have not changed.

How to protect your portfolio against inflation?

This is a very stylized example, but it should be clear enough: an inflationary environment is a riskier environment. In the absence of relative price stability, investors demand a higher level of compensation for the additional risk of holding stocks. And so, all other things being equal, stock prices will fall once investors see inflation as a cause for concern.

MacInnes illustrates this with the example of Hershey, the American chocolate maker, and how he negotiated in the 1970s. MacInnes notes that in the years 1972 to 1975, Hershey “successfully passed on increases in input costs on consumers, so that revenues and operating profits have increased significantly “. In short, the company has done exactly what one would expect from a quality stock with pricing power: it beat inflation to the point where earnings per share rose by over 65%. between 1972 and 1975.

Yet over the same period, the p / e ratio collapsed from 16 to 6, which saw the stock price fall by a third over the period (and at one point up to two-thirds). So you can’t rely on stocks as a group to protect your portfolio from the ravages of inflation.

So what can you do? MacInnes points out that it is clear that some sectors have done well during inflation. The energy sector is one (it is doing well at the moment too); commodities is another, and some financial firms should do well too. In other words, mainly the things that have been beaten in the last ten years.

It also suggests that passive funds tracking a broad index are unlikely to be the best solution in a bear market driven by inflation.

I’m not saying for a minute that active funds typically outperform in bear markets (they don’t) – what I’m saying is investors are going to have to be a bit more picky than a large tracker if they want their portfolio to survive and even thrive in an inflationary world.

After all, you can get industry exposure with many passive vehicles such as exchange-traded funds (ETFs).

In the latest issue of MoneyWeek magazine – the one published now – our guest editor, high-value investor Andrew Hunt, takes a look at oil, and more specifically the oil and gas service industry. Suffice it to say that he believes we are only at the start of a very powerful bull run for this sector, and he is browsing through several promising stocks around the world.

If you haven’t already subscribed, get your first six issues (plus a free copy of my book, The Skeptical Investor) by registering now

And we’ll be discussing the death of the 60/40 wallet – and what could replace it – at the virtual MoneyWeek Wealth Summit. If you haven’t signed up for this yet, you should really – I suspect it will be worth more than the price of admission for this conversation alone.

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