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):

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."