Is above-average inflation coming? While the inflation rate hasn't reached crisis levels since the early 1980s, the rising cost of select consumer items lately (like gasoline), as well as the massive increase in federal spending, has concerned some Americans that the rate may finally be on the rise.
Whether or not it appears, preparation by investors for increased inflation can bring some peace of mind, and holding stocks such as Amazon (AMZN 3.15%) and Chevron (CVX 1.20%) can protect your portfolio. Let's find out more about why these two stocks can thrive even when inflation increases.
At first, a retail stock may not seem like a winner when consumers are contending with falling purchasing power. However, Amazon built its reputation in part on price competition. Some scholars point to the "Amazon Effect," or the downward movement of prices when Amazon enters a market as the company has singlehandedly intensified price competition in many markets. Amazon also cuts costs by investing in few physical stores and performing many of its own deliveries.
Moreover, the cloud, where Amazon derives the majority of its profits, can subsidize costs. In 2020, retailing produced a 3% net profit margin. This compares to the 30% margin for Amazon Web Services (AWS), its cloud division. Since stores like Walmart and Costco Wholesale do not operate secondary high-profit non-retail businesses, the cloud business gives Amazon a significant competitive advantage.
It's little wonder that Amazon grew net sales by 38% in 2020 to $386 billion. This led to an 84% increase in net income to $23.1 billion. Amazon faced a 36% increase in operating expenses as equity-related revaluations increased income by more than $2 billion, more than making up for about $300 million in reduced income from falling interest income and rising interest expenses.
Amazon only provided a financial outlook through the first quarter. Investors may prefer to see full-year projections from the company. However, growth could slow for a time as consumers return to in-store shopping amid a receding pandemic. This has probably made Amazon reluctant to guide more than one quarter out. Nonetheless, Amazon still projected 33% to 40% revenue growth for Q1.
Also, its current growth left Amazon with $20.3 billion in free cash flow in 2020. This leaves Amazon with $84.4 billion in cash and equivalents, a position that will allow it to manage its long-term debt of $31.8 billion. Hence, inflation has little chance of compromising its balance sheet.
The fact that Amazon's stock price rose by about 65% over the last 12 months should hearten investors. And although a P/E ratio of approximately 80 may appear elevated, Amazon's earnings growth seems to justify that multiple.
Since Amazon only offered one quarter of guidance, investors should factor that uncertainty into their investment decisions. Still, considering Amazon's retail and cloud leadership, as well as its cash hoard, Amazon has positioned itself to prosper regardless of whether inflation becomes a factor in the near future.
For all of the talk about alternative energy, the fossil fuels Chevron produces remain by far the most popular energy source among consumers. In 2019, petroleum and natural gas accounted for 69% of energy use in 2019, according to the Energy Information Administration (EIA).
This plays into Chevron's hands. Despite targeting higher returns and a lower environmental impact, Chevron's main source of profit is still fossil fuels. Moreover, hard assets such as oil and gas tend to hold up in an inflationary environment. No entity can print energy, and Americans need these fuels to sustain their lifestyles. If past oil price spikes offer any indication, higher prices, whether brought by inflation or other causes, will probably accrue directly to Chevron's top and bottom lines.
Additionally, the fact that Chevron drills, transports, and refines energy products means energy-price fluctuations do not affect Chevron stock as significantly as it does for pure-play oil drilling companies, which often sustain stock price volatility when oil prices fall. This diversification allowed Chevron to ride out the pandemic as the contagion brought unprecedented declines in energy consumption.
Chevron also appears in stronger shape than archrival ExxonMobil. Chevron's debt, which increased by $17.3 billion, went up in part because it assumed $9.4 billion of Noble Energy's debt when it acquired that company.
Still, that deal increased Chevron's proven oil reserves by 1.7 billion barrels, increasing the likelihood that the Noble assets will generate returns over time. In comparison, ExxonMobil's $21 billion debt increase in 2020 went to shore up the dividend and address falling production.
Also, even after the increase, Chevron maintains a net debt ratio of only 33%. Moreover, lower rates helped to drop interest expenses by $100 million. Hence, the higher debt should not threaten the dividend.
Admittedly, the $1.7 billion in free cash flow it generated in 2020 did not cover the $9.7 billion in dividend expenses. Also, some of the increased debt likely covered dividend costs.
However, the company reported $13.1 billion in free cash flow in 2019, before the COVID-19 pandemic began in the United States. Thus, the payout will probably return to sustainability after the pandemic ends. Fortunately, the company also holds $5.6 billion, a cash hoard that will probably grow should inflation raise oil and gas prices.
Investors should also remember that the dividend payout has risen for 33 years in a row amid a variety of oil price environments. The streak of payout hikes gives Chevron Dividend Aristocrat status. Since breaking such a streak could significantly diminish confidence in the company, Chevron will probably increase the dividend this year, providing yet another inflation hedge. With an annual dividend of $5.16 per share, shareholders currently earn a 5% yield.
Chevron's resilience amid the pandemic helped its stock price rise by just over 20% over the last year. While Chevron still has not recovered all of its losses from the pandemic, it continues to improve as revenue levels recover.
As consumption returns to pre-pandemic levels, the recovery will probably continue with or without inflation. Should inflation reappear, it would probably make that growth trend more pronounced as investors seek shelter in hard assets.