6 Stocks to Hedge Your Inflation Risk

One shouldn't overstate the problem: Given the spare capacity in the economy, inflation is unlikely to be an immediate risk. However, investors shouldn't turn a blind eye to the medium-term risk: It's entirely possible (dare I say likely) that Fed Chairman Ben Bernanke has grossly overestimated his ability to stuff the inflation genie back into its lamp if it is unleashed. In that context, investors should consider now what sort of assets would offer effective protection against a loss in purchasing power.

The new dynamics of wage inflation
With unemployment at 9%, only Chicken Littles are concerned about inflation. Think again. That 9% figure is misleading. If you believe, as I do, that the unemployment rate that represents full employment has increased during this crisis, the economy could experience upward pressure on wages ahead of the predictions of Fed models. In other words, if full employment occurs with 7% unemployment instead of 5%, the people who are employed could demand and obtain higher wages sooner than we expect. Note, for example, that the unemployment rate among college graduates was just 4.2% in January.

Siegel's right about this
I'm not a big fan of Jeremy "Stocks for the Long Run" Siegel -- one of the high priests of the cult of equity. However, I agree with him when he wrote recently that "dividend-paying stocks should be the choice of the conservative investor," ahead of inflation-protected government bonds. This is not a new strategy: In December 1937, Barron's ran an article titled "75 Hedges Against Inflation or Deflation" focused on dividend stocks.

These 75 hedges were the product of a screen to identify stocks that paid a dividend in every year of the Great Depression such that the lowest dividend equated to a yield of at least 4% on the stock price at the time the screen was run. I ran the same screen on the Russell 3000 over the period 2008-2010 -- the three years since the start of the Great Recession. Fewer than one in 10 stocks (236) made the cut; out of these I picked six for the following table, with an eye to durable competitive advantage (the only reliable source of above-normal returns):

Company

Projected Yield*

Altria (NYSE: MO  ) 6.2%
Leggett & Platt (NYSE: LEG  ) 4.6%
People's United Financial (Nasdaq: PBCT  ) 4.7%
Redwood Trust (NYSE: RWT  ) 6%
Eli Lilly (NYSE: LLY  ) 5.7%
Fidelity National Financial (NYSE: FNF  ) 3.5%

Source: Capital IQ, a division of Standard & Poor's.
*At Feb. 14, 2011, based on the latest annualized dividend per share.

Let me say a few words about two stocks that I find intriguing.

Better than Annaly
One stock that made the cut, but that isn't in my table is Annaly Capital Management (NYSE: NLY  ) . It's a favorite stock around The Motley Fool and beyond -- PIMCO's bond guru, Bill Gross, selected it as one of his two picks for the 2011 Barron's Roundtable in January. The REIT earns a spread on the money it borrows and reinvests in mortgage-backed securities (MBS). I mention Annaly because I think it is highly overrated compared to a stock I did include in my table, Redwood Trust which also invests in MBS (among other activities).

Redwood has one characteristic that I find very attractive compared to Annaly: permanent capital. At the end of September, more than four-fifths of Redwood's assets were financed by equity, with long-term debt representing just 11.4% of assets. Compare that to Annaly, which was leveraged nearly 7:1 at the end of the fourth quarter. Furthermore, Annaly needs to roll over its debt continually -- nearly all of its debt is in the form of (short-term) repurchase agreements. Combine a stable source of capital with Redwood's strict value discipline and you have all the elements for earning better-than-average returns. Interested in more information on Redwood Trust? Add it to your Fool stock watchlist by clicking here.

This lilly is a scrapper
Pharmaceutical giant Eli Lilly, like many of its peers, is facing important patent expirations that will create a revenue shortfall in the years to come. However, the company has distinguished itself with proactive and innovative approaches to research and development. At the beginning of the last decade, Lilly created InnoCentive, a virtual platform for funding external research. This was instrumental in the development of Cialis, Lilly's blockbuster competitor for Viagra.

Today, Lilly is seeking to partner with venture capital to raise up to $750 million to seed three funds that could cover as many as 20 experimental medicines in different therapeutic areas. Patent expirations are a challenge for Lilly, but I think the company is addressing this head-on, and it looks well-positioned to produce satisfactory returns on behalf of shareholders.

It's your turn
Let me know your thoughts on the risk of inflation and your preferred inflation strategies in the comments section below. If you're looking for more stock ideas, The Motley Fool's analysts have identified "13 High-Yielding Stocks to Buy Today."

Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. Fidelity National Financial is a Motley Fool Inside Value pick. The Fool owns shares of Altria Group, Annaly Capital Management, and Fidelity National Financial. Try any of our Foolish newsletter services free for 30 days.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (11) | Recommend This Article (33)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 18, 2011, at 5:13 PM, inflationbytes wrote:

    These are good options if we are moving into a slightly higher than normal inflationary expansion mode. Also excellent selections if there is some sustained downward pressure on the market. BUT, that is not the address we live at today I am afraid. Instead I believe, though I hope I am wrong, that we will be looking at significant inflationary force--yes it may very well be hyper-inflationary--and at some point a sizable currency devaluation. If either of these occur, dividend yields will not retain their luster. Must be looking at other options.

  • Report this Comment On February 18, 2011, at 8:31 PM, NovaB wrote:

    Compare dividends. I'll keep my Annaly and you keep your Redwood. NLY and I have been good friends for about 10 years with a 145% retrun. No Chipolte but still respectable.

  • Report this Comment On February 20, 2011, at 9:27 AM, paul7777777 wrote:

    I looked in the history of Redwood and was really shocked how much that stock has lost his value, that was one of the worst stocks to buy in the past. So I stick rather also to Annaly and enjoy a more then two times higher dividend.

  • Report this Comment On February 21, 2011, at 12:08 AM, Merton123 wrote:

    The best hedge agaisnt inflation is to invest in companies that do business in Europe. As the American Dollar devalues the Euro Dollar may take its place as the international currency of choice. For example Nestle (Swiss Company); Diago (German Company?); will do very well in an inflationary economy. They sell products that people will buy even if they lost 50% of their net income. They sell primarily into Europe so the American investor gets the slow growth in those markets and also add the American Dollar devaluation agaisnt the Euro.

  • Report this Comment On February 21, 2011, at 12:25 PM, jimmy4040 wrote:

    If you're worried about inflation, it makes no sense whatsoever to buy didvdend yielding stocks, since it's unlikely that the dividend will keep pace with inflation.

    I like Merton123's idea above, EXCEPT that I don't like the euro. So ouside the US, ok, Europe is a no go for me.

    The writer is wrong about inflation btw it has already taken hold quite well.

    For me, the obvious choice through the end of this year is the financial industry, an area where MF is surprisingly weak. The steepening yield curves has already been a bonanza to these companies, and Bill Gross believes no rate increas by the Fed this year.

    Dump these divident choices, and buy financials, but ONLY on the dips.

  • Report this Comment On February 21, 2011, at 12:45 PM, commentator123 wrote:

    This statement is absolutely untrue - both on external funding and that innocentive had anything to do with the development of Cialis. Check your facts!

    "At the beginning of the last decade, Lilly created InnoCentive, a virtual platform for funding external research. This was instrumental in the development of Cialis, Lilly's blockbuster competitor for Viagra."

  • Report this Comment On February 22, 2011, at 4:27 PM, TMFAleph1 wrote:

    @commentator123

    If you have a better source than the Financial Times, I'm all ears.

    Alex Dumortier

  • Report this Comment On February 22, 2011, at 4:29 PM, TMFAleph1 wrote:

    @jimmy4040

    <<If you're worried about inflation, it makes no sense whatsoever to buy didvdend yielding stocks, since it's unlikely that the dividend will keep pace with inflation.>>

    Thanks for your comment, but what's your basis for this statement?

    Alex Dumortier

  • Report this Comment On February 22, 2011, at 4:31 PM, TMFAleph1 wrote:

    @paul7777777

    <<I looked in the history of Redwood and was really shocked how much that stock has lost his value, that was one of the worst stocks to buy in the past. So I stick rather also to Annaly and enjoy a more then two times higher dividend.>>

    What the stock has done in the past has no bearing whatsoever on whether it is currently a good investment.

    Alex Dumortier

  • Report this Comment On February 22, 2011, at 5:23 PM, surfgeezer wrote:

    Ok, throw my stratedgy out. Fist the inflation will come from increased demand of commodities world wide, coupled with a decreasing dollar relative to the net exporters currencies, means greater inflation for US. So my basic goal is to get tied into the building blocks that EVERYONE needs. Oil trusts, coal trusts, pipelines, things that people NEED, not want. Also, I like out of country, but will stick with strong countries (low debt, exporting commodities) so you are tied to their currency. Like Canada, Brazil, Australia. NO Euro, Japan. Also like financials mREIT and BDC's. Commodities and financials all MUST have good divvys for cash flow if needed.

  • Report this Comment On February 25, 2011, at 11:15 PM, NJBiologist wrote:

    @TMFMarathonMan--Tadalafil was an Icos product. If you look at CDER application 21-368, the applicant is Lilly Icos, a joint venture formed by the two companies to develop tadalafil into Cialis. Note also that the manufacturer's signatures are dated 2001, the year Innocentive started. The work was already done before Innocentive existed.

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