SKEPTIC’S GUIDE TO INVESTING
Straight Talk for All, Nonsense for None
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Your Hosts - Meet Steve Davenport, CFA and Clem Miller, CFA as they discus the latest in news, markets and investments. They each bring over 25 years in the investment industry to their discussions. Steve brings a domestic stock and quantitative emphasis, Clem has a more fundamental and international perspective. They hope to bring experience, honesty and humility to these podcasts. There are a lot of acronyms and financial terms which confuse more than they help. There are many entertainers versus analysts promoting get rich quick ideas. Let’s cut through the nonsense with straight talk!
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SKEPTIC’S GUIDE TO INVESTING
Inflation's Impact: Strategies Beyond Bonds
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In today’s episode, Steve and Clem discuss (and debate) the idea of replacing a portion of your bond holdings with a satellite portfolio of assets that that may offer a superior combination of yield and inflation resistance.
We consider the fact that inflation, while moderating significantly, is far from conquered. We also wonder if Fed rate cuts might actually prompt a return to higher inflation. Last, we wonder if we’re overdue for a sizable equities correction, especially among those AI and pharma stocks that have had a good run.
For this inflation-proofing satellite portfolio, we look at REITs, utilities, and natural resource equities, including energy, mining, and agriculture.
All of these assets have advantages with respect to yield and inflation resistance, but whether they offer total returns superior to those of general equities is open to question.
Steve and I welcome you to share your insights and continue the conversation.
Straight Talk for All - Nonsense for None
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Hello everybody and welcome to Skeptic's Guide to Investing. I'm here, this is Clem Miller, and I'm here with Steve Davenport, and today we're going to talk about inflation, which is an issue which seems to be persistent in the US economy. Seems to be persistent in the US economy. Steve today has been doing a lot of work on the subject of inflation, on how to think about the issue, on how to position portfolios and pick stocks and other securities that might do better in an environment of continuing inflation. Let me start, Steve, by saying to what extent do you think inflation will continue to be a persistent problem? After all, it seems, at least the rate of increase in prices seems to have slowed. I know that it's not going down, so there's a lot of price resistance you don't have. Typically, prices go up or remain stable. They don't go down, Right Right. But how do you think about, you know, the overall macro environment and inflation? Let's start there first. Well, when?
Steve Davenport:I look at, the markets in the last two or three years have certainly been challenging in terms of understanding. If you want to own the top seven to 10 names, your portfolio grows at an above average rate, and so if there's an inflation of assets, then I think that inflation probably exists in the space of AI and some of these you know healthcare, you know the, the obesity and weight drugs. I think that there is inflation in the underlying system that we think is moving in the right direction, and it's still growing, still a factor, but it's not as much a factor at three and a half as it is or three as it is at five and a half and six. So, yeah, we're moving in the right direction on inflation, but there are signs out there that some of these things might, you know, not be completely under control, and so I've had a lot more people asking what you know? What do we want to own besides big tech that is going to continue to do? Well, as we start to see the Fed lowering rates and so lowering rates itself, in many people's mind, could be inflationary of how many more rate cuts we get before we start to say, oh, this is trying to solve one problem, which is the cost of our national debt on a regular basis, and what are we going to do when inflation is stickier and more problematic?
Steve Davenport:And maybe I look at the case of housing right how is housing going to have lower rates and not have an effect in terms of more demand and more inflation in housing? It feels like these two things cannot coexist the way that people expect them to. So we've seen an unbelievable move in housing during COVID, and it has to do with where people want to live and what the areas are, and areas that were lower cost have seen rises that are greater. Areas that are expensive have gotten more expensive, and so when I look at inflation, I try to think about things that are going to go up in the equity space as we see the financial and economic characteristics unfold in the next few years, and if we believe we're going to see a 2% reduction overall by the Fed over the next year, a year and a half rates are going to be lower.
Steve Davenport:Housing will become more available to more people, because now the ability to purchase is going to be stronger for each of those buyers. So they've also had a good move in the markets. So if you were using the markets as your down payment to try to help you get into that first home. I think that we know that it's going to be challenging. You're going to need all that Google stock and Amazon stock and Broadcom stock that you can get your hands on. And I think when I approached this, I first said I want to take away the question about duration in the Fed, because when I look at people, they're not really sitting there saying hmm, and now at three and a quarter, I feel like we're discounting the cash flows at an appropriate rate.
Steve Davenport:Based on my risk, that's not really happened. So when rates are high, people want into cash and they said, hey, I can take very little risk and sit here in treasuries and have a nice 5%, 6% return. That was a beautiful place. Now that we move down, the question becomes is it still such a beautiful place? And what happens if we get down to 3 and a half and then we see a spike back to five and a half? That movement and that effect on your fixed income portion of your portfolio will be that, hey, that higher inflation is going to hurt you, and so my question was is there a way for us to construct something on the side as a satellite to your regular equity and regular fixed income, that might give you some extra boost when we start to see inflation being more persistent or more difficult?
Clem Miller:So what I did is I tried to pick five or six areas that I felt were going to Steve, before you get into the details, let me ask you a bit about your comment about creating a satellite portfolio. Is this something that is an emergency portfolio If you need it, you break the glass or is this something where you would have it as a fixed percentage of your overall portfolio?
Steve Davenport:I think it belongs in what I'll call the messy middle or the portion of your portfolio. That's not equity, that's not bonds, but it has characteristics that you like and, as one of the diversifiers, so I would say it's a 5% to 10% allocation to something that you believe is important to help you battle inflation. So when I look at the portfolio right now, it has a yield of about 3.5%, and when I think about 3.5%, I look at it and say, well, equities are averaging about 1.5% for the S&P. 3.5% seems to be compensating me for some of that extra risk. Then I look at it and say what's the growth rate of those dividends of these companies? The growth rate is about 5%. So my question is is inflation going to grow by more than 5%, such that these rates are not going to be significant to me anymore? And so I'm not calling for rates above 5. I am saying they might go from three to five, and in that way this portfolio would tend to perform pretty well. So I think that when I look at these areas, they just feel like they could be timely when I start to consider what the markets could do in the near future.
Steve Davenport:And I'll start with the elephant in the room, which is energy. So I believe that energy is a big. The Fed likes to say well, we follow inflation for everything but food and energy, and they quickly say that energy is too volatile and therefore we can't try to control or manage it. And I look at it and say energy offers you a lower PE. Energy offers you an above-average yield. Energy offers you something that when there's problems in the Middle East or problems in various parts of the world with energy production, the price is affected, and so that higher price that eventually translates into your pump and into your car has some impact on you, and especially if you're a lower income or medium income. So I think energy matters and therefore we need to own some energy as a hedge to part of the-. So the portfolio is made up of one fifth energy stocks, one fifth REITs. Reits are very sensitive to interest rates and as we come down in interest rates after going up very suddenly, reits are going to be a beneficiary right away because the cost of their debt is going to go down and as that cost goes down they become more profitable. So if we're going to see rates go down, which is the base case of another 150 or 200 basis points, then I think that REITs are a place that will help you in this space around inflation. The third area is utilities. Utilities, by law, can go back to the regulator and say our costs are inflating at this rate, we need to make a rate adjustment. So that ability to adjust rates gives these companies an ability to compensate and help you to offset what is not easily upset if you're just in a fixed income portfolio.
Steve Davenport:The fourth area is metal and mining. We've seen a great move in gold, we've seen moves in copper. We see, you know, I think that when you think about the commodity space, you've got metals, you've got oil and energy, you've got agriculture, you've got areas that all are going to be the core items that lead to the inflation in your bag of goods, and so owning the names that are producing those items gives you an advantage in terms of having some effect that these companies are going to adjust and they're going to be able to make more money in an environment that is going to be good for metals and mining, and I think that the infrastructure bills that are being passed around the world are all going to eventually come down to. We need cement, we need steel. We need basic components and building blocks, copper and those copper and other items are going to be useful members of your portfolio to adjust as inflation starts to rear its head or continues to rear its head. And then we've got agriculture I think is the last.
Steve Davenport:So I've looked at these areas and said I'm not necessarily in the best position to say who and what are the leaders. So therefore, I looked at portfolios, looked at an energy ETF, looked at a REIT ETF, looked at which ones are being chosen on a regular basis and how does Morningstar look at them in terms of four stars, three stars and whether they have a moat. So our process is pretty simple with Morningstar data, but it does start to show you that some of these names have not participated. When I look at the energy space or I look at the metal space, these have been laggards for years. Therefore, my question is is the world going towards AI and computers and we're not going to need steel, aluminum, gold or any of these other items and metals in mining?
Steve Davenport:And the answer is no. These are fundamental building blocks and therefore they should be a part of your portfolio. And when the interest rates go to, if we go to 2.5 in the Fed short-term rate. I've got to say to you OK, you've got 2.5% there, or you've got 3% with a 5% protection against inflation. Is that something that you'd prefer owning a company versus owning a bond? And I think that this is where it's not easy to make comparisons. I call it the messy middle because they're not really equities and utilities are equities technically, but they operate a lot like fixed income.
Clem Miller:Yeah. So, steve, I got a few questions for you, okay, so let me take them. I don't have a particular order in which I want to take them, but let's start with metals and mining. So you know the things that go into making windmills like the rare earth metals, windmills like wind turbines. Let's say, um, the, the rare earth metals. Uh, you got the, the gallium and the germanium which you are used to so-called dope semiconductor chips. You've got lithium, which goes into the lithium batteries. You know, would you favor? You know those newer types of metals over the? Uh, old school? You know steel and iron and whatnot that would come out of, say, australia.
Steve Davenport:I'm looking at all types of metals and some of the you know, the Vale and the Nuant Mining and other places have small parts of their business that are in these specialized metal spaces. And then others, like Alba Marley, is very much focused on lithium and batteries. This list of names I wanted to have the big players who are largely involved in the standard large commodities, but I also have some smaller ones. There's a small company called FMC that we own that is very much into the agriculture space and specialized fertilizers. So, yes, there could be better large companies, but I wanted it to be representative of the overall space.
Steve Davenport:And so, yes, I considered some of the metals that are involved in the EV space because they're bound to grow and bound to see demand. So it's not like we can find and predict the actual. You know these five metals are going to have the highest growth rate and therefore these five companies are associated identically with those five metals. It's a you know it's a lot like when you say I want to own financials and you own GE. You know GE had a huge financial part of their business, so it's not.
Clem Miller:you know business. So my next question is with regard to the REITs. So which kinds of REITs Are you talking about? Commercial, industrial, residential? I mean? What are you looking at?
Steve Davenport:I'm looking at a combination of all. I'm not making one call and saying, hey, we want 100% in hotel REITs, that's where the value is. But what I'm saying in general is I think the concept of REITs, because of a declining interest rate market, make these different REITs probably a good, you know. So I'm looking for some infrastructure. So when you think about, you know, the cell towers, for some infrastructure. So when you think about, you know, the cell towers, I'm looking for some retail. I'm looking for where I consider to be four and five star opportunities on Morningstar in the REIT space. And with you know, the problem with REITs is that Morningstar does classifies them as having no moats because they can be easily duplicated with financial assets. And I've looked at it and said, hey, I think that, yes, they can be. But there are some names that have, I would call, an advantage in terms of, and one of those examples is in timber.
Clem Miller:And one of those examples is in timber.
Steve Davenport:So I think that when we look at these assets, we have to say we're not going to make perfect the enemy of good. I think that overall, the concept is 20% of REITs. Make sure you own things that are good value, make sure you own things that have good growth prospects, and they could have a tailwind associated with interest rates.
Clem Miller:Yeah. My next question is with regard to I would say there's dividend yield, obviously, or coupon yield, right, but there's also buyback yield. You can look at share buybacks, say in the technology space, but really anywhere, as a form of yield. I mean, the obvious example is Berkshire Hathaway, which does buy back shares even though it doesn't pay a dividend. This is also a form of yield, and so why wouldn't we want to be looking at buyback yield in addition to dividend yield?
Steve Davenport:looking at buyback yield in addition to dividend yield. I think if we were focused on more on total growth, total return, I think you're right, we should be focused on buyback yield. I'm really looking for a replacement to bonds and so when I look at replacing my bonds and saying I could go out on the duration curve and get a higher number or I could replace it with a higher yielding stock, that I think is maybe below what the bond yield is and maybe not as risk-free but has the potential to maintain the rate it has because of the long string of dividend increases. So I agree that total return wise, you would need to consider more buyback yield.
Steve Davenport:But when I'm looking at these, I'm looking at saying, ok, I take, you know, if I have 5% to 10% and I take 5% from fixed income and 5% from equities, from fixed income and five from equities, I'm going to replace it with characteristics that are going to be about half of a fixed income entity, which is 5%, would give me about 2.5% of the yield, and an equity entity that has a 3% yield with half would put me another one and a half, which puts me at about 4%. So I look at the 4% rule as kind of the I don't know the most popular way to think about distribution. It's simple. It's not perfect, it adjusts with inflation, but if we're going to have a rule, it's a rule that a lot of people are familiar with, and so that's where I try to get to in terms of something that I think most people would find useful, in that they could set it and forget it.
Clem Miller:So my next question is with regard to recession risk, you know, when you talk about energy and you talk about mining, you know these are cyclical uh industries. They have a higher beta uh to the overall market uh, which you know when uh. Or to the economy, so when the economy, which you know when. Or to the economy, so when the economy, global economy is going up, there are, you know these companies do better than if the economy is going down. So you know, I'll just you know China hasn't been doing so well in terms of its economy and I guess you could say, to some extent, india is offsetting that, but China has not been doing so great. And so you know, how do you look at this question of marginal demand for the actual products of these companies? I mean, how do you balance that off the whatever inflation benefits you get by investing in these companies?
Steve Davenport:Sure, I think that we know that the data from China can be a little suspect. I think that I worry about how much China represents in the overall global demand and how much of it is going to be impactful for the rest of the world. I look at the environment right now as having turned from we're fighting inflation to we're now fighting for growth, and I know that China is going to do things and has done things to already tell you how they're going to address the growth. And I don't know if they're complete. I don't know if they're successful, I don't know if they're going to. You know it's going to work, but I'd say that in general, I feel like there's been a turning point.
Steve Davenport:The central bankers in Europe, the central bankers in Japan, the central bankers in China are all on the same page. We've had higher rates. They did their job, they crushed inflation, which I think might be a little bit arrogant, but let's just say they've been successful. And now the question is does the success permeate and do you want to? You know, if you were to look at a climb and say, I've got two choices I can buy names with higher yield who are in this space as inflation fighters, or I can buy an inflation-linked bond. Which one would you buy and what duration would your inflation-linked bond? Which one would you buy and what duration would your inflation-linked bond have?
Clem Miller:To be honest, in my mind that's kind of a false choice.
Steve Davenport:Well, what is your asset that's going to keep up with inflation?
Clem Miller:I think, if you look at the data, especially over the long run, equities are the way to go in terms of inflation protection. It gives you positive real real meaning inflation adjusted. It gives you positive real returns, significant positive real returns over time.
Steve Davenport:And I'm not just talking about big tech, which is an obvious example of that.
Clem Miller:I'll give you another example which are luxury goods. I don't know why you wouldn't invest in luxury goods, and maybe you do invest in luxury.
Steve Davenport:I think that luxury goods involve more than just a commodity. It's not a commodity of luxury.
Clem Miller:Well, yeah, it's not a no, but I'm looking for an inflation fighter and I would say that you know, if you look at at uh, you know if you look at ferrari and you look at lvmh and so on, that these are companies, uh, that do well in any kind of inflation environment, because their customers really will buy those products regardless of how much they cost, and so I think these companies offer some inflation protection.
Steve Davenport:Yeah, I think you can be right. I'm not saying that there aren't names, that we haven't covered, that my list is is all inclusive. All I'm saying is that I think when we, when we look at the world environment in terms of where we're going in terms of interest rates, interest rates are going down and if you have that support, then what names are likely to succeed and produce results that I mean, I'm just talking about the yield on these names. But if you take the yield plus appreciation for these names, they far exceed bonds. So you're going to the other extreme saying, well, what about all the growth of your names?
Steve Davenport:That growth is a great offset to inflation. I would say that right now, the market is near its all-time high and therefore, if you're recommending that we take 5% on equity and 5% on bonds and put it into something, putting it into growth of your equity at this point isn't the answer for inflation.
Clem Miller:No, you and I are coming at it. It has to be a little bit. You and I are coming at it from different perspectives. That's basically what it is, you know. You're coming at it from a let's move from bonds to to something other than high growth stocks, and I'm looking at it more from a perspective of within the equity universe. What would be the best equities to deal with inflation? I think, other than that at least from protection against recession you want to have in.
Clem Miller:You want to. I mean at least from protection against recession you want to have some in cash.
Steve Davenport:Yeah, I think that a lot of these companies are more conservatively managed because they have a very long time horizon. Because, you know, drilling and all the things that need to happen in order for you to produce an end product involves risk and capital, and these companies are very capital intensive. I'm not saying that these are the best if you take all equities in terms of growth to offset inflation. What I'm saying is that you're already allocated in a way to take advantage of growth and now the question is should you be allocated to some other things if we believe that growth is going to be tougher to come by in the tech space and other spaces? Therefore, should we be in items that are more hard asset-based and I think that they're not making more land? So these timber companies are owners of land that can be used for mineral rights, air rights, chemical, you know, and I think that all of them have advantages. It's just that they're not AI advantages, right, of course, I look at it as a new source of alpha Right. Rates are coming down.
Clem Miller:Right. So, Steve, let's wrap up for the day. I really appreciate this conversation. I think it was very enlightening, should be enlightening for our listeners, even though we have a few disagreements on some of the advantages and disadvantages of these sub-asset classes.
Steve Davenport:I have this argument with my partner all the time about growth and value. Is there a place for value in your portfolio, or should we just hold on and just grab for the ride of the roller coaster that is growth? I believe that you need to have a mix. My suggestions here are simply ideas as to how you might think about what's going to benefit as rates come down and if inflation were to rear its head. Would you want to then go to shorter? You know, if you go short in duration, you're going to get hurt as rates keep coming down, and if you go longer in duration and rates go back up, you're going to see capital declines.
Clem Miller:Bonds are dangerous. It's just one solution. Bonds can be dangerous if you don't do it right. Bonds can be dangerous Absolutely.
Steve Davenport:I'm not a lover of bonds and so I just want people to realize that there's other solutions out there and other ideas. There certainly are other solutions out there and other ideas, so I'm a little skeptical that we're not going to have a little pullback, like we did yesterday and today in the tech space, and that's going to make people uncomfortable, and if I can make them more comfortable by taking some of the profits off and putting it into something like this inflation fighting, it might make a client feel more comfortable and ultimately, that's what you want.
Clem Miller:So, steve, let's wrap up, and I appreciate all of our listeners. Please contact us. If you have any questions or comments, please like us, please share with everybody and this wraps up this. Thanks, steve, and this wraps up this edition of Skeptic's Guide to Investing. Thanks a lot.
