Under the Radar Report

HOW BLUE CHIPS CAN PROTECT YOU FROM INFLATION

25 March 2022
Richard Hemming

I’ll give you one reason to hunt for value: Sleep, or for those insomniacs, Contentment. That’s what Blue Chip Value provides for subscribers. It’s no accident the Blue Chip Value Portfolio’s recent outperformance of the benchmark S&P/ ASX 200 Index is accelerating. In the past two years, Blue Chip has returned 34.9% versus the Index’s 31.4%.

You might not outperform when the bulls are running and investors are paying up for blue sky, but you will be keeping up. Then, when the going gets tough, as is inevitable, the hunt is on for value, which refers to companies that aren’t expensive and aren’t sexy, but have earnings certainty and more often than not, pay dividends.

As we have mentioned previously, growth is fine, in fact it’s very good. But your return depends upon how much you are paying for it. When investors pay too much for growth they get whacked by a double whammy: lower earnings and a lower earnings multiples.

The big fear in the markets, as we’re all aware, is inflation.

Before I get into “Blue Chip Inflation Busters” it’s necessary to look into the background of why inflation is leading bond markets to factor in higher long-term interest rates. What caught my eye, was the benchmark US 10 year Treasury bond yield racing through 2% this month to as high as 2.4%. It’s 2.3% as I write, up from levels near 1.8% in February.

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A great deal of commentary is aimed at discussing inflation, or the rate of change of prices, and on “real” economic growth or real GDP (gross domestic product), which is adjusted for this. The key measure, however, is nominal GDP, which is the value of goods and services produced in an economy over a quarter and then annualised.

Central bank action is based on nominal GDP, because it is the best representative of the strength of aggregate demand in an economy.

In 2021 evidence has come to light that both the US and Australian economies were running hot, with nominal GDP growing at an average annual rate of 10%, which in the US was the highest in four decades and in Australia, the highest in two. This is highly significant because it is double the historic average.

But isn't growth good?

When economies run hot, production can’t keep up with demand, which is what causes inflation. Economists and central bankers cannot ignore this.

But the evidence is that they did, which is why inflation in the US is running at 7%, while in Australia at 3.5%, which are both much higher than long-term averages, and much higher than subdued wages growth.

The nominal GDP print outs show that central bankers in our markets got it wrong and should have been raising interest rates earlier. This is the reason why at every opportunity in recent weeks US Federal Reserve chair Jerome Powell and the RBA’s Philip Lowe are saying that they’re going to tighten monetary policy, which means raising official interest rates and shrinking the balance sheet by halting purchases of government bonds, reversing the effects of Quantitative Easing. Lowe, for instance, famously said that there would be no interest rate rise before 2024 and now anticipates increases this year.

Why didn't the central banks act earlier?

The delay in tightening occured because of uncertainty about the economic outlook principally due to the pandemic; and also because they didn't want to tip the economy into recession because of a once in a century event.

These views did not sufficiently account for continued expansionary fiscal policy under the new Biden Administration in the US.

A key point is that even before the supply side shocks, in commodities such as oil & gas, relating to the war in the Ukraine, inflation was going to be a factor. The war simply hastened the inflationary tide.

How to Protect your Portfolio

In Under the Radar: Small Caps issue 490, we highlight 16 inflation busting stocks in our 110 stock Research Rundown. Many of these companies are disruptors, which can achieve earnings growth at the expense of bigger companies.

But there is no doubt that some Blue Chips have significant pricing power, which protects their sales line. This means that they can increase the volume of goods and services sold without having to discount much because there is an element of inelasticity in demand. Consumers don’t look for substitute goods as quickly.

This is why in our Blue Chip Portfolio table, in BCV issue 100, you will see a heavy weighting towards banks, mining companies and infrastructure, such as telecommunications.

On the other hand, it’s also noteworthy that there are not stocks whose value is based on blue sky, or growth into the never never. As bond yields go up, this means the risk free interest rate goes up, and has investors become averse to risk, they pay lower earnings multiples for stocks, which means the equity risk premium also goes up. These blue sky stocks get hit hardest in market weakness (remember the double whammy effect).

Remember, investing in value means that you don’t have to worry as much about your net worth when the world hits the skids from conflict or from inflation running rampant.

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ABOUT THE AUTHOR

Richard Hemming

Richard Hemming (r.hemming@undertheradarreport.com.au) is an independent analyst who edits www.undertheradarreport.com.au, which provides investment opportunities in Small Caps that you won’t get anywhere else.

Under the Radar Report is licensed to give general financial advice only (ASFL: 409518). The author does not own shares in any of the stocks mentioned.

Under the Radar Report is licensed to give general financial advice only (ASFL: 409518). The author does not own shares in any of the stocks mentioned.