Investing in Stocks as a Long-Term Inflation Hedge
With the the rate of inflation reaching forty-year highs in the United States, and similar records being set around the world, investors have been understandably concerned about the need to grow wealth in real purchasing power terms. The promising news is that, while past returns are no guarantee of future returns, a reasonably diversified portfolio of common stocks has historically proven to be a magnificent inflation hedge provided the holding period is sufficiently long.
In fact, the extent of this success is astonishing. As Dr. Jeremy Siegel wrote in the 6th Edition of his seminal work, Stocks for the Long Run, from 1802 through 2021, total real returns – that is, after inflation – on U.S. stocks have averaged 6.9% per annum, turning $1 into an $2,334,920 in purchasing power by the end of the period. This occurred despite that same $1 declining a breathtaking 95.7% in real inflation-adjusted terms to a mere $0.043. In contrast, bonds grew to $2,163 in real terms, Treasury Bills to $245, and gold to $4.06.
The reason for this phenomenon: Equities represent ownership of real, productive assets; machinery, equipment, intellectual property, and the like. While inflation can do tremendous harm to the intrinsic value of capital-intensive businesses, many excellent businesses are capable of absorbing higher input costs and counteracting the added expense with price increases to end-consumers. In cases where these products and services are essential – consumer staples being a perfect illustration as individuals and families, rich and poor alike, will not do without the things they deem essential be it toilet paper, paper towels, laundry detergent, soap, toothpaste, chocolate bars, whiskey, tobacco, etc. – such enterprises often handle the adverse environment with aplomb despite short-term shocks to reported earnings.
An Example of a Stock That Has Been a Fantastic Inflation Hedge for 50+ Years
In the 3rd Quarter 2022 Private Client Letter, I used Kimberly-Clark Corporation as a real-world example of how a wonderful business has not only survived, but thrived, through periods of horrific inflationary pressures such as the 1970s and 1980s. Even with no dividend reinvestment, real earnings per share kept ticking higher and higher, resulting in the real inflation-adjusted dividend per share showered on owners of the enterprise rising in actual purchasing power terms. An owner of Kimberly-Clark Corporation, in other words, not only found their stock worth exponentially more by the end of the roughly half-century period, but enjoyed this increase while receiving a constant stream of increasing real purchasing power in the form of a cash dividend that could be used to fund other investments, pay for food, clothing, and/or shelter, take vacations, support friends and family, or make charitable donations. Whether they were sleeping, at work, reading a book, or taking a walk, Kimberly-Clark was generating operating profit from selling toilet paper, paper towels, and other necessary paper products.
It may be useful to revisit the entirety of the text given its importance to thinking about the role of inflation when investing in stocks. Specifically, I wrote:
“Several years ago, I mentioned that one of the general practices we had begun adopting was targeting at least a modest Kimberly-Clark Corporation holding for nearly all private client portfolios. Typically, we would seek to put at least 2.50% of an account to work in the world’s largest and most profitable manufacturer of paper products, going as high as 5.0%+ for certain clients who had a need for passive income or who were nearing or in retirement. As with all capital allocation decisions, this differed on a client-by-client basis, varying with our analysis of what was in the best interest of a specific client in light of the unique circumstances spelled out in the fiduciary agreement.
There were numerous reasons for this operation. At the time, interest rates were near zero and the dividend yield was much higher than not only fixed-income securities, but stocks as a whole. The company was attractively valued. The products that generated sales and earnings to fund those dividends were absolutely essential to the well-being of individuals, families, and institutions around the world with near ubiquity in most places – to reiterate some relevant facts, 1 out of 4 people use a Kimberly-Clark product every day and its products can be found in 175 countries and locations; products that range from diapers, toilet paper, tissue, and paper towels to cleanroom and lab supplies for hospitals, biotech groups, and advanced manufacturing facilities. It is not an exaggeration to say Kimberly-Clark is one of the industrial giants that makes the world run. Few other companies could hope to have the scale, scope, resources, and expertise it does in its markets.
While it may seem boring, the grand old consumer staple giant routinely generates a return on capital that puts it scores above most non-technology companies in corporate America, especially when you consider it has managed to do this in times of severe economic and political stress. To be clear, it is not just that the company has been profitable, but that it has remained consistently profitable regardless of the challenges thrown at it provided you give it enough time to adapt. These surplus returns have been sufficient for it to use the bulk of its free cash flow to distribute large and growing dividends, as well as repurchase common stock to reduce the share count outstanding.
To demonstrate how these forces have enriched owners over the past half-century, including during times of elevated inflation, take a look at the real (net of inflation) increase in purchasing power of the dividend per share over the past fifty-one years (fifty full years plus an estimate for the current year, 2022, based upon an extrapolation of the company’s present quarterly dividend rate).
Kimberly-Clark Corporation – 50+ Year Nominal and Real Dividend Analysis
|Year||Split-Adjusted Dividend Per Share||Absolute Increase in Dividend Per Share ($)||Relative Increase in Dividend Per Share (%)||Inflation / CPI Rate (%)||Real Change in Dividend Per Share (%)||Real Purchasing Power of Dividend Relative to 1972 (%)||Stock Splits|
Note, too, that the figures presented in the prior table do not assume any dividend reinvestment. An owner of Kimberly-Clark who routinely plowed his or her dividends back into the stock would have experienced a far higher rate of real purchasing power growth in total dividend income than the per share rate alone, dividend compounding upon dividend. An investor who was wise enough to regularly add capital to pick up even more shares on top of this dividend reinvestment did far better.
As the saying goes, the past is not a guarantee of future performance. That acknowledged, the dividend yield of Kimberly-Clark now sits comfortably in excess of 4% per annum, making it more attractive than it has been in a long time. We see no indication that the characteristics and advantages that allowed it to thrive since 1872 have been diminished. If anything, those characteristics and advantages appear stronger than ever.”
One of the Best Ways to Combat Inflation Is To Go Through Life Accumulating Ownership of Such High-Quality Stocks
I could have substituted numerous other businesses for the Kimberly-Clark Corporation in the above illustration – The Hershey Company, The Coca-Cola Company, PepsiCo, Procter & Gamble, Colgate-Palmolive, Brown-Forman, McDonald’s Corporation – and proven the same point. The take-away is that successful investing, in particular successful value investing, often means identifying the wonderful businesses that you want to own then waiting for a reasonable (or better yet, deeply undervalued) price. If you’re fortunate, you may get the opportunity once or twice per decade when you can make a large commitment that can really move the needle. Then, the game is to wait and let those businesses do what they do best: Generate free cash flow that can be used to pay dividends, repurchase shares, or that can be plowed back into expansion through either organic growth or acquisitions.
While it sounds like a simple prescription, an overwhelming body of evidence and research indicates that a vast majority of investors are psychologically and temperamentally unable to do this. Put simply, investors as a whole are notorious for not earning the same return as the underlying assets they own. This occurs because they buy and sell at the wrong time, don’t have an optimal asset allocation, and don’t take advantage of certain techniques like tax-loss harvesting when it makes sense to do so, among other reasons. In fact, even when dealing with just ordinary mutual funds, including index funds, Vanguard, the multi-trillion dollar asset management company has repeatedly published research in its Advisor’s Alpha whitepapers indicating that those working with a financial advisor can see “Up to, or even exceed[ing] 3% in net returns” above what they would have earned had they managed their own portfolio. In fact, for the 20 years ended December 31st, 2019, research by Dalbar, Inc. showed that the perfectly average investor earned a compound annual rate of return of only 4.25% per annum versus the S&P 500 generating 6.06% per annum over that same period.
Going back to our Kimberly-Clark Corporation example, the stock, like essentially all stocks, regularly collapses in quoted market price. In 2016, it hit a high of $138.90 before falling to $97.10 a couple years later in 2018, meaning after several years of holding, you watched 30% of the market value of your position be obliterated. In 2020, the stock hit a new high of $160.20 before collapsing back down to $108.70 per share in 2022 for a wipe-out of more than 32% of your quoted market position. Over and over again this scenario plays out, year after year, company after company, with investors making decisions based upon what is happening in the market and not what is happening in the business.
This folly is not benign. It is, perhaps, understandable for those not familiar with finance and possessing a rare temperament of mind. With the exception of some of the greatest value investors in history, how many folks were willing to buy stocks in 1974 when, according to Dr. Jeremy Sigel, “real stock prices, measured by the Dow Jones Industrial Average, had fallen 65 percent from the January 1966 high – the largest decline since the crash of 1929. Pessimism ran so deep that nearly half of all Americans in August 1974 believed the economy was heading toward a depression such as the one the nation had experienced in the 1930s.” [Ibid] The situation was so bad that, five years later on August 13th, 1979, BusinessWeek ran a front-page story called “The Death of Equities: How Inflation is Destroying the Stock Market“. The timing could not have been worse as the United States was on the verge of the greatest bull market run in human history.
The Unappreciated Risks Inflation Imposes on Equity Investors
Relatedly, it is important to point out that inflation has other consequences for equity investors. Most notably, the U.S. tax code does not adjust capital gains for the rate of inflation meaning that if an asset is acquired at $100 and sold at $105 but inflation ran 10% and the owner lost real purchasing power, that owner would still be forced to pay a capital gains tax on the $5 nominal profit despite being poorer. In a way, this creates a purposeful mechanism through which governments can confiscate private savings. It is neither moral nor equitable. Unless and until the tax code is modified, the best mechanism for investors holding assets outside of tax shelters such as a tax-deferred retirement account is to minimize turnover; to allow businesses to compound, seeking to profit from their long-term rise in intrinsic value not from short-term changes in market quotation.
(Interestingly, this ideal behavior, if adhered to by a fiduciary financial advisor, presents a risk that clients prone to activity feel their portfolio isn’t being managed enough; they feel as if they don’t see enough buy or sell orders to justify paying for advice despite it being a sign that the advisor is behaving as it should – a true fiduciary acting in their best interest. The paradox is fascinating from a sociological perspective but horrifying when you realize how much wealth is destroyed by the typical person’s bias towards action. For a fiduciary investment advisory firm like Kennon-Green & Co., this isn’t a problem we run into frequently because we specialize in value investing for affluent and high net worth individuals, families, and institutions. That means we are dealing with a self-selected crowd of people who have amassed a lot of money on their own and who generally understand the goal is to do intelligent things, waiting until something materializes. For investment advisors dealing with smaller, general retail accounts, it’s likely a fair statement to say most of their time is spent managing people – keeping their clients from making mistakes – rather than portfolios.)
The Types of Businesses to Consider and Avoid When Looking for a Long-Term Inflation Hedge
Generally, the best businesses to own long-term when experiencing inflationary pressures have several characteristics. They have low capital needs relative to the amount of operating profit generated, resulting in significant free cash flow. Holding all else equal (which, in the real world, is rarely the case), as cost inputs rise, replacement of property, plant, and equipment will likely be less than the corresponding increase in prices passed on to end-customers resulting in a tailwind effect that enriches stockholders. An excellent illustration would be payment processing companies such as Visa and Mastercard. Leaving aside the potential political risk of Congress intervening with the firms’ respective business models, revenues are largely tied to economic activity expressed in nominal dollars. Similarly, chocolate companies, candy companies, carbonated beverage companies, essential software-as-a-service companies, etc. are other enterprises for which input costs are not likely to overwhelm the ability to increase prices.
Conversely, the worst businesses to own long-term during inflationary environments are those for which two things are true: 1.) The balance sheet consists of a relatively enormous proportion of property, plant, and equipment necessary to conduct operations and 2.) the product produced by the company demonstrates commodity-like behavior.
A simplified illustration demonstrating the above concepts might be helpful. I’d like for you to imagine two hypothetical businesses. We will call them Company A and Company B.
|Company A||Company B|
|Net Income: $25 million||Net Income: $25 million|
|Return on Invested Capital: 40%||Return on Invested Capital: 8%|
|Capital Necessary for Business to Operate: $62.50 million||Capital Necessary for Business to Operate: $312.50 million|
Both companies generate the exact same net income of $25 million per annum. However, presuming that return on invested capital remains steady, Company A must only add another $62.50 million to the capital base to double earnings to $50 million per annum. To achieve the same feat, Company B would need to come up with $312.50 million in additional capital, bringing the capital base to $625 million. As input costs rise, the task of maintaining, let alone growing, earnings becomes far more difficult for Company B than for Company A.
Now, further imagine that Company A were trading at 20x earnings and Company B were trading at 12.5x earnings. Despite the latter seeming to be a greater bargain, – a base earnings yield of 8.5% versus 5.0% for the former – nothing could be further from the truth. In this case, assuming both businesses have no meaningful change in the operating environment, Company A is likely to work out to be a far superior holding over the decades. It’s not only the superior inflation hedge, it is likely to generate exponentially more free cash flow that can be distributed to either enjoy life or used to buy additional investments.
These are the sorts of ownership stakes we are interested in for private clients of Kennon-Green & Co. Truly great businesses, when bought as part of an intelligently-designed overall portfolio, can be the gift that keeps on giving provided owners are willing to patiently wait for an attractive price, hold for years, perhaps even decades, and suffer through the inevitable 50%+ drops in market price that can occur, have occurred, and almost assuredly will continue to occur in the future.
Buy great businesses, pay a reasonable price, hold through thick and thin provided the underlying intrinsic value remains intact, and inflation is far less of a long-term concern to you than your emotions, your neighbors, or the news would have you believe.