November’s inflation figures, the highest since 1982, now raise questions that could impact a wider swath of American business in 2022. Few consumers will have missed the recent rise in energy prices or product shortages caused by continuing supply chain problems. With the prospect of inflation running hotter than it has in many years, how should stock investors react?

Traditionally, many assets that are best-suited for income and capital preservation goals perform better in times of inflation.  Master limited partnerships, bonds, preferred stock, and precious metals are often recommended for individuals seeking protection from inflation.

Within our purview of stocks, there are a few areas where investors might seek to add or increase exposure during inflationary times. For instance, real  estate investment trusts (REITs) offer yields along with the prospects of capital appreciation. In today’s climate, though, REITs that focus on industrial properties, communications infrastructure, or data centers might be more suitable than those that focus on residential or commercial properties.

Gold and precious metals are usually considered hedges against inflation. Stock investors can profit from increased demand for gold by owning shares in a gold mining company. Most pay a decent dividend, and owning a gold miner or streamer/royalty company is less complex from a tax perspective than holding gold directly.

Another sector to consider is financial services. Banks and insurance companies tend to benefit from the rising interest rates that accompany inflation.

Regional banks in particular (those that still make money on the business of banking instead of by charging fees) can see their profitability increase as rates increase. Well-managed banks that have been able to churn out profits in low interest rate environments will be breathing a sigh of relief as rates rise and their margins can expand.

Insurance companies offer essential services, so they tend to weather economic weakness quite sturdily. Higher interest rates can allow their investment income to increase as they invest customers’ premiums before payouts. In addition, the best insurers are able to increase premiums as interest rates rise.

All of the above is not to say that investors should consider making wholesale shifts in their strategies. A well-diversified portfolio—one that includes companies from many different sectors and industries, encompassing defensive as well as cyclical businesses—will likely have some component of the portfolio that is working well during every twist and turn of the economic cycle.

Like a homeowner’s insurance policy that must be in place if it is to cover a household disaster, diversification only works if the portfolio is properly constructed in advance of times of high inflation or economic slowdowns. Maintaining proper diversification should always be a primary objective.

Patience is also key. There is lots of talk about whether November’s steep price gains are a sign that coming inflation is “transitory”—a temporary bump in the road—or “structural”—that price increases will stick around. If there is any lesson to be learned from the activity in the U.S. economy and stock market in the last two years, it’s that swings and roundabouts are now commonplace. With Covid lingering about, making predictions about where the economy and market is headed in the short-term remains a futile endeavor.

If higher inflation is permanent, then wages and business operations will adapt. When pressed, the best American businesses know how to increase efficiency, and they will continue to do so in the future.

That leads to perhaps the biggest takeaway about managing the impact of inflation as an investor. Companies that have pricing power can raise prices when their costs go up, maintaining, or sometimes even expanding, their profit margins. Companies with profit margins higher than their peers can even give up a little margin and still remain competitive.

The strategy we use in the SmallCap Informer focuses heavily on examining the underlying profitability of a company as evidence of the strength of management. In the face of higher inflation, we expect companies that past our tests of management have added margins of safety that allow them to navigate in times of uncertainty.

Taking another look at your current holdings to assess the strength of their margins when compared to peers could be one practical move you make before or after you celebrate the New Year. You might be glad you did.

• DOUGLAS GERLACH

Reprinted from the January 2022 issue of the SmallCap Informer.

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