Long or Short: Inflation

The great inflation/deflation debate rages on. Some economists worry inflation will rear its ugly head and kill the purchasing powers of savers. Others believe deflationary forces cannot be stopped and will likely wipe out those with heavy debt burdens. With the two sides so far apart, I'll make the case for both, give you my opinion, and present some ways we can position our portfolios accordingly.

Inflation is on its way
Ben Bernanke hates deflation. In November 2002, Bernanke gave a speech titled "Deflation: Making Sure 'It' Doesn't Happen Here," in which he outlined deflation's antidote: the Federal Reserve's printing press. The Fed chairman has already printed $1.25 trillion to purchase toxic mortgage-backed securities from banks, and some think the Fed's balance sheet could balloon as high as $5 trillion.

There's just one thing standing in the way of inflation right now: the more than $1 trillion in excess bank reserves with the Fed. As soon as banks turn those reserves into new loans, watch out. Inflation could spread like an epidemic.

Deflation is here to stay
There's a big problem with that argument. The data don't support it, as inflation is not increasing. In fact, two inflation measures -- the consumer price index (CPI) and the personal consumption expenditures index (PCE) -- have been inching closer to zero lately. A number of factors are contributing to disinflation, including a falling money supply, continued credit contraction, and businesses' hoarding cash. If these trends continue, product and asset prices could start to fall and disinflation will turn into deflation.

My Foolish take
I am short inflation and have been for quite a while. But that and $3.25 will get you a tall skinny vanilla latte. The question is, "How can I use this information to manage my investments?" Fortunately, Gluskin-Sheff Chief Economist and Strategist David Rosenberg laid out the keys to positioning your portfolio for a deflationary environment. Let me go over my top three.

1. High-quality companies (noncyclical, high cash reserves, minimal financing needs): If you want quality, look no further than Coca-Cola (NYSE: KO). There's never a bad time to drink one and it's a cash cow -- $8.8 billion of cash and $8.2 billion of operating cash flow in 2009. Moreover, it needs only about $2 billion for capital expenditures to fund its operations and future growth. Plus, it's selling at less than 20 times free cash flow.

2. Reliable dividend growth and yield: There are plenty of companies with strong dividend yields and consistent dividend growth. But two stood out in my screening results: McDonald's (NYSE: MCD) and Procter & Gamble (NYSE: PG). These two blue-chip stocks have yields above 3% right now. P&G's dividend per share has grown at an average rate of 12% for the past five years while McDonald's dividend averaged a sizzling 30% growth. We can take their yields and growth straight to the bank.

3. Low debt/equity and highly liquid asset ratios: The current ratio measures a company's current assets divided by its current liabilities. A number greater than two indicates a very liquid balance sheet. Master of sound enhancement Dolby Laboratories (NYSE: DLB) and biotech giant Genzyme (Nasdaq: GENZ) are two prime examples. Each has tiny slivers of debt and plenty of cash. They're leaders in their industries and we don't have to worry about their balance sheets. That's an attractive combination in a deflationary environment.

Summary
If you believe deflation is on the way, cash is king. That's because cash today will have greater purchasing power tomorrow. The companies have plenty of cash to use and distribute to shareholders. That's how they can help deflation-proof your portfolio.

So what do you think? Is inflation or deflation on the way? Share your thoughts in the comments section below. And if you have individual stocks ideas to tackle either one, be sure to bring them to CAPS.

Million Dollar Portfolio co-associate advisor David Meier does not own shares of any of the companies mentioned, but he is using Dolby sound reduction right now. Coca-Cola is a Motley Fool Inside Value pick. Dolby Laboratories is a Motley Fool Stock Advisor selection. Coca-Cola and Procter & Gamble are Motley Fool Income Investor choices. The Fool owns shares of Coca-Cola and Procter & Gamble. The Motley Fool has a disclosure policy.


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