How to Beat Inflation

By James B. Stewart
July 6, 2004

SO THE BIG DAY came and went last week — June 30 — and, just as I predicted, reaction to the Federal Reserve's decision to raise interest rates a quarter point was fairly muted. Markets rallied briefly on Chairman Alan Greenspan's reassuring words that future increases will be "measured," but then headed south. This wasn't because the Fed raised rates, but because of fears it didn't raise them enough.

It turns out that fear of rising rates was yesterday's worry. Today's is inflation. Greenspan keeps insisting that, if you strip out soaring energy prices, inflation isn't a threat. And it's true that, not counting oil, inflation measures are comfortably within Greenspan's target of a 1% to 2% annual rate.

But traders are skeptical. Greenspan's credibility took a hit last year when he kept warning about deflation, and none appeared. Now there's plenty of anecdotal evidence that producers are raising prices and making them stick. The dollar has been weakening, commodity prices rising.

As usual, it's not for me to weigh in on a debate that divides even expert economists. But I think prudent investors should at least be prepared for the possibility that, after a remarkably long period of little or no inflation, we are entering a new period. So how should we prepare?

I recently reviewed a study by Cambridge Associates examining how various asset classes performed in a high-inflation environment. During the period 1973 to 1981, the last (and one of the worst) high-inflation periods, the best-performing asset class was oil and natural gas (with annualized returns of 31% and 29% respectively). Next was timber, at 22%; real estate, 14%; commodities (other than oil and gas), 13%; government bonds, 6%; and the S&P 500, 5%.

I certainly don't think it's likely that we'll experience anything like the inflationary cycle of the 1970s, so these returns may not be representative of a far milder inflation period. Nonetheless, I think investors should have exposure to some of these sectors, both as a potential inflation hedge and because, after years of neglect, they are relatively undervalued despite recent gains. (I'm not going to discuss TIPS in this column, which was the subject of a mutual-fund article on this site a few weeks ago.)

Oil and gas. This is probably the easiest sector for the average person to invest in, both through large, diversified energy companies and through limited partnerships. The Cambridge study noted that the so-called downstream energy producers — a category that covers refining, production, marketing and distribution — provide the least protection against inflation within the energy sector. What investors should look for are the so-called upstream companies — oil and gas exploration, oil-field services and ownership of reserves.

As readers of this column already know, I have recently been selling stock in the big downstream energy companies like ChevronTexaco (CVX) after their recent large gains. But that doesn't mean I've abandoned the energy sector. I've recently bought some limited oil and gas partnerships — Kinder Morgan Energy Partners (KMP) and Enbridge Energy Partners (EEP) — and I've kept my holdings in Apache Corp. (APA), which owns big oil and gas reserves. Although the energy partnerships are yield-oriented, and thus are adversely affected by rising interest rates, they offer some interest-rate protection, since rising oil prices enable them to boost their dividends. I also own two drilling companies, Noble (NE) and Smith International (SII), and I'm considering expanding my holdings in the drilling and oil-field-services area. There are also plenty of mutual funds in this area, and also exchange-traded funds, but look carefully — most of them are dominated by the big downstream companies like Exxon Mobil (XOM) and BP (BP). One good option is the HOLDRS Oil Services trust (sorry, no snapshot), which focuses on the drilling and exploration sector.

Timber. As an asset class, timber caught fire last year after Harvard University revealed that it had shifted a major part of its huge endowment into forest land. There are timber partnerships and managers out there, but the minimum investment is typically $1 million, and sometimes many times that, with lock-up periods of 10 years or more. There are only two publicly traded timberland trusts available to investors: Plum Creek (PCL) and Rayonier (RYN). Both offer yields of more than 4%.

An alternative is to buy shares in a publicly traded forest-products company like International Paper (IP) or Boise Cascade (BCC). I haven't found any ETFs that focus exclusively on forest products, but there are many diversified ETFs and mutual funds that focus on natural resources. Again, look closely at their holdings, because most of them have heavy exposure to the oil and gas sector.

Real estate. Despite its proven record as an inflation hedge, I'm cool on real estate at the moment, because of the likelihood of still higher mortgage rates. Chances are, you own a house or apartment already, so you have a built-in inflation hedge. Still, REITs have sold off during the past few months on fears of rising rates, and they aren't as overvalued as they once were. If prices begin to look more attractive, I'll look for some alternatives in a future column.

Commodities. Let's start with gold. And, please, all you gold bugs, don't deluge me with email about the virtues of gold, as you always do every time I mention the topic. I don't like gold, period. Let me simply point out that from 1973-2003 gold was the worst performing asset category. Ditto more esoteric precious metals like platinum.

But if you want a little exposure to gold and other metals, as well as a diversified basket of commodities, there are ETFs that are pegged to various commodity indexes, including the Goldman Sachs Commodity Index (tracked by the iShares Goldman Sachs Natural Resources Index Fund (IGE)).

Another possibility is buying stocks in metals companies or mutual funds that focus on copper, nickel and other mining companies. Such companies include Phelps Dodge (PD) and Freeport McMoran (FCX). There are plenty of others that sound pretty exotic — how about Southern Peru Copper (PCU)? But I don't know much about these.

In the days of high-flying technology stocks and nonexistent inflation, no one paid any attention to these stodgy sectors. With a strengthening global economy, higher demand for raw materials and the recent whiff of inflation, they're suddenly glamorous. I'm not one to follow trends, but inflation moves in long-term cycles. This one could just be beginning.




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