5 Tips for Investing in an Inflationary Environment

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According to Reuters, inflation is starting to pick up in the U. S. While the consumer price index has shown relatively low inflation over the past several years the fact remains that the Federal Reserve has been rapidly increasing the monetary base. The reason that this hasn’t caused enormous inflation to this point is that the velocity of money, or how quickly this money changes hands, is at record lows. This is sustainable for a long period of time, but not indefinitely. Therefore I think investors need to start preparing for inflation.

Here are a few tips.

First, many assets that seem like they are good assets to own during inflation are not. For instance many stocks will not be good investments during an inflationary period. As inflation rises, the returns that investors will demand on their investments will rise. This will push earnings yields higher and price to earnings ratios lower. Only stocks of companies that are able to outgrow this multiple contraction and trading at low earnings multiples already will be good investments.

Second, don’t buy inflation protected Treasuries, or “TIPs.” These are bonds that are designed to correlate returns with the consumer price index. But the consumer price index is not necessarily a good measure of inflation, especially since it excludes food and energy. Furthermore keep in mind that the gains you realize on your TIP holdings are taxed as ordinary income, and so you end up losing some of the inflation protection you might have gotten.

Third, be careful in commodity producing companies. The clearest beneficiary of inflation is commodities, and investors believe that commodity producing companies are going to be beneficiaries because the prices of the things they produce are rising. But input costs are rising too! Depending on the company and the commodity your performance can be outstanding, or it can be dismal. Be very selective when picking commodity producing companies.

Fourth, buy royalty and streaming companies. Royalty companies make deals with mining companies to buy a certain amount of gold at no cost. Streaming companies make similar deals except the cost is fixed. While some streaming deals have inflation clauses these companies are going to deliver the full benefit of a rising commodity price to its investors.

There are only a handful of royalty and streaming companies, and they mostly operate in the precious metals space. The largest — Silver Wheaton (NYSE:SLW) — focuses on silver, but it also has some gold exposure. There is also Franco Nevada (NYSE:FNV), which focuses on gold but which also has exposure to platinum, palladium, and oil. These companies have outperformed not only precious metals and the market, but their peers in the mining sector.

Fifth, consider commodity ETFs, and dig deep. There are several new commodity ETFs on the market with investor interest rising over the past couple of years. Picking the best ones is not easy but taking the time to do so will pay off. For instance many investors are aware of the SPDR Gold Trust (NYSEARCA:GLD) as a way to get gold exposure. But they probably aren’t aware of the Sprott Physical Gold Trust (NYSEARCA:PHYS), which gives investors gold exposure but which also has a tax advantage if you hold it for more than a year. Unlike GLD — which is taxed at 28 percent as a collectible — PHYS is taxed at the capital gains rate (15 percent or 20 percent).

Furthermore, be very selective when choosing particular commodities. Consider that as inflation fears pick up more and more investors will want to protect themselves from rising prices. Therefore commodities that appeal to investors — i.e. commodities that hold a lot of value in a small amount of space and that are easily stored — will get an extra boost from added investor demand. For instance sugar might be a good investment, but investors aren’t going to stockpile sugar. They will, however, stockpile things like gold and platinum. You can hold $10,000 worth of gold in the palm of your hand, but $10,000 worth of sugar is over 25 tons!

Ultimately preparing for inflation is more difficult than it might seem. But if you use a little common sense, you can weed out the ideas that won’t work and stick to the winners.

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