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Portfolio Management in an Inflationary Environment

Below I’ve cut/paste a great article from Gary Dvorchak discussing inflation, its cause, and how he manages client money given the current environment. The three areas of the market in which he believes we should be invested are exactly the areas we also emphasize in our investment strategies.

He does get a bit callous about the impact on the people impacted by the real estate crash, but maybe a dose of reality is called for in this momentous shift in the world economy. Please don’t be offended if you think that no one cares about the people who are losing their homes and jobs. That is not his point at all – his point is that in a capitalistic society, you have freedom to choose your occupation and investments, but you also have to accept responsibility if those choices don’t pan out.

I really enjoyed his writing and I hope you do, too. If you are managing your own money, you could do worse than accept his advice. You’ll have to determine your own timing and develop your own investment strategy – or hire us to do it for you.


Mark

The Disciplined Investor: Cover Your Assets

By Gary Dvorchak

Sometimes the complexity of developments in the economy and on Wall Street get the best of my simple mind, and I need to find a base to really understand what is happening — and how to position for the implications. I find the best way to analyze the economy is sometimes to simply look out the window.

As I gaze from my vertigo-inducing perch in downtown Los Angeles, I first see a number of large office buildings. Some were owned by Equity Office, some by Maguire, some may soon be owned by the lenders. But the buildings will be there tomorrow and the day after, and someone will show up to work in them.

I gaze farther toward the San Gabriel mountains and the famed Inland Empire, where large swaths of shiny new homes sit gathering dust at the edge of the desert. They aren’t going away now that they exist, and they will all eventually be occupied by someone — most likely at a price lower than the builders hoped.

We paper-shufflers on Wall Street tend to overfocus on the flickering pixels on our screen and ink shapes on our monthly statements, and sometimes forget to better contemplate the real economy going on out there while we fight over who gets what. The seminal truth is this: Our economy underwent a massive overbuilding in the housing sector, and no amount of paper-shuffling, TAFs, interest rate cuts, etc. can undo this massive misallocation of real resources.

The only cure for the economy is to have the contractors, the mortgage brokers, the lenders and all the other participants in the boom move on and find something new to do. This process is well under way. Thousands of square feet of office space in Orange County now sit empty since the New Centurys of the world shut down. (And thankfully, I now get one or two refi offers a day in the mail, instead of 10-15.)

Mortgage brokers are learning the new upsell: “Would you like fries with that?” Contractors call desperately looking for remodel projects, completely ignoring the do-not-call list laws. The homebuilders are cutting staff as fast as they can be shown the door. The process is well under way, but it will not be complete until all these laid off people are productively redeployed in new and different industries. That means a sharp recession at worst and a “rolling recession” at best, in which slow to no economic growth ensues while a succession of industries adjust to the new reality. I used a quote in the Jan. 29 The Edge, which is worth repeating:

“Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed into hopelessly unproductive works.” — John Stuart Mill, 1867

Massive amounts of capital were destroyed over the last four years, and the process on Wall Street and in the banking sector is now about assigning the losses. What is important to the investment strategies of readers of this site is this: There are only two ways to assign the losses, either to those responsible or to society at large.

The fact that the Fed and other central banks are injecting hundreds of billions of liquidity into the system indicates that we’ve chosen the latter course. (By the way, I don’t criticize the effort. Money does matter to the real economy, and the threat of a complete meltdown of the financial system, with Depression-era implications, is very real.)

Every investor must recognize and embrace the reality that the Federal Reserve is choosing to use inflation to distribute the losses as widely and thinly as possible. Furthermore, you must embrace how to position yourself in inflation plays in order to assign your share of the losses to some other sucker who isn’t paying attention. The Fed and other banks are creating massive amounts of money now, and, as sure as night follows day, that money supply growth — in the absence of accompanying economic growth — will translate into higher prices.

The dollar is screaming this to you right now. Oil is screaming this at you. (Oil is already up nearly 10% since breaking the once-unthinkable $100 mark.) Gold is screaming this to you. Commodities are screaming this to you. If you really don’t believe it, ask your spouse what she (or he) spent at Safeway last week. Those “Ingredients for Life” now include inflation. To cover your assets and offload your share of the pain, investors need to be positioned in inflation plays, weak dollar plays and pricing power plays.

  • Inflation plays benefit directly from rising prices, and include commodity names — and companies levered to commodity price changes. Examples include agriculture names, oil exploration and production, the drillers and miners.
  • Weak dollar plays are any company that benefits from the falling dollar, either from greater overseas demand, lower domestic costs, or foreign exchange translation gains. Most tech names benefit, as most sales are overseas. Other large exporters, such as a Caterpillar (CAT) , will benefit as well.
  • Finally, pricing power plays are names that can pass through inflation-driven price increases quickly. The tobaccos are classic, as the demand curve is nearly inelastic. Big pharma can price in all environments. Some consumer names with strong brands can price aggressively, too. McDonald’s (MCD) strong comps yesterday show the fast food giant’s ability to both price and benefit from overseas business. (And it benefits from the tradedown effect in a weak economy.) Long McDonald’s/short McCormick & Schmick’s Seafood Restaurants (MSSR) would be a good example of a pair trade to capture the deflating hopes and dreams of the aspiring restaurant-goer.

Here are some of the inflation/dollar/pricing names I own in the fund my firm sub-advises, the Landmark Capital Disciplined Growth Fund (LCDGX):

  • Pure in
    flation plays include Mosaic (MOS) , EOG Resources (EOG) , Occidental Petroleum (OXY) , Deere (DE) , Exxon Mobil (XOM) , Flowserve (FLS) , Archer-Daniels-Midland (ADM) , Barrick Gold (ABX) and National Oilwell Varco (NOV) .
  • Weak dollar plays include Oracle (ORCL) , Microsoft (MSFT) , Research In Motion (RIMM) and Hewlett-Packard (HPQ)
  • Pricing power plays include UST Incorporated (UST) , Loews Carolina Group (CG) and McDonald’s.