With high food and energy prices across the country, everyone's feeling the pinch from inflation. Yet while stocks typically give your portfolio some inflation protection, some particular stocks perform really badly when prices are rising.
How stocks fight inflation
In general, stocks resist inflation's impact on purchasing power far better than bonds do. With bonds, you're stuck with whatever interest rate your bond is paying. Typically, inflation forces rates higher, making your relatively low interest payments less valuable. Also, because bonds offer only a fixed payout when they mature, inflation devalues your eventual payout as well.
Stocks, on the other hand, feature something bonds don't: the potential for growth. Rising prices mean that companies can charge customers more for their products, increasing profits. In particular, companies with relatively fixed costs can benefit greatly from inflationary periods, because any price increases fall directly to their bottom lines.
The value of pricing power
Not all companies, however, are lucky enough to have their internal costs insulated from inflation's effects. If higher prices for raw materials force companies to pay more to make their products, then their profits will suffer -- unless they can immediately pass those costs on to their customers in the form of higher prices. That pricing power translates into how well a stock can handle inflation.
Many companies have good pricing power. Strong brands like Coca-Cola (NYSE: KO) can count on loyal customers to bear price hikes. In addition, businesses that sell necessities, such as Kraft Foods (NYSE: KFT), can often leave customers with no choice but to pay higher prices.
In particular, several sectors of the economy are having a lot of trouble with lack of pricing power right now:
- Despite higher energy prices overall, refiners like Valero (NYSE: VLO) and Frontier Oil (NYSE: FTO) have suffered, as crude oil costs have risen much faster than gasoline.
- Airlines like AMR's (NYSE: AMR) American and UAL's United have tried to pass on higher fuel costs to passengers through baggage fees and fuel surcharges, but competition prevents them from simply hiking fares to compensate fully.
- In a down housing market where we continue to see new lows for home construction, building materials suppliers like USG (NYSE: USG) and Vulcan Materials (NYSE: VMC) have little ability to charge struggling homebuilders more for their products.
Without pricing power, higher costs lead to narrowing profit margins and lower earnings growth. In turn, deteriorating financials often cause share prices to drop, as investors see slower growth and reduce the earnings multiples they're willing to pay for a stock.
Signs of trouble
To protect your portfolio from inflationary troubles, it pays to keep your eyes on quarterly reports for your stocks. Although the reduced demand from higher prices may cause falling revenue growth, that by itself isn't necessarily cause for alarm. If, however, lower revenues are accompanied by tighter margins and more substantial drops in earnings, it should become clear that your company isn't responding to inflation in a healthy way.
It's clear that with current low yields, bond investors are vulnerable to continuing inflationary pressure. Yet just because you own stocks doesn't mean you're automatically protected from inflation. Only by owning businesses that can pass rising costs through to customers can you count on steady increases in the value of your stock portfolio.
For more on investing during hard times, read about:
- The stocks you should own in a choppy market.
- One simple strategy that could save your portfolio.
- Our guidebook for investing in down markets.
