Inflation Fears? Get Back to the Basics of Buffett and Lynch.

Adem is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

"In Trade off With Inflation, the Fed Chooses Jobs"-NY Times

"Fed Wants Inflation Now, Will Clean Up Mess Later"-Mohamed El-Erian/CNBC

"Fed's Fischer Says U.S. Inflation Expectations Rising"-BusinessWeek

I don't claim to be an expert, but it's clear that the experts agree. With the recently implemented policy of QE3 Federal Reserve Chairman Ben Bernanke has decided to stop containing inflation. This isn't a criticism of Bernanke, his bold move to purchase $40 billion of mortgage backed securities isn't revolutionary (i.e. QE1, QE2). What is different this time is that the Fed has decided to continue purchasing the securities every month until employment improves substantially. With this move, the Fed become somewhat "politicized", by trying to absorb bonds it hopes to provide stability to and grow the economy; as the Fed's bond purchases will keep interest rates ridiculously low and push investors to purchase stocks.

The downside of course, to this money printing policy is inflation, which the Fed has clearly decided is the least of all evils. This can be a real problem for your savings and investments. If you are in cash you risk your dollars being diluted and worth less in the future. What about bonds? Forget bonds. The Fed wants you to be in stocks, owning treasuries which yield less than the typical 2.5% dividend of stocks makes no sense, and those rates may be going even lower! But even if you own stocks, you risk the possibility of inflation rates (the cost to buy goods) rising higher than your returns; therefore leaving you less well off.

 

So What's the Foolish Investor to Do?

You've probably heard that gold is a natural hedge against inflation and a shaky dollar, which is true. When currency is in question investors flee for the precious metal, for the best ways to play gold, click here. Outside of gold and gold stocks there are some really simple steps you can take to protect yourself from inflation. You'll want to be in stocks first of all (Bernanke has given us little choice), and to find the right ones to fight inflation you don't need to be a rocket scientist. Just screen for stocks that follow these simple 3 principles that investment sages Peter Lynch and Warren Buffett (2 and 1, respectively) love to see in companies.  By doing so you'll have a good chance of finding companies that are inflation killers.

 

Pricing Power

That's right, to beat inflation you need to find the companies that can afford to charge 5, 10, or even 20% higher for their products and still add new customers. This is something Warren Buffett calls a "moat"; it's that special advantage that allows remarkable companies to fend off competitors. This could be anything from a brand, huge market share, or a unique "network effect", to name a few. I won’t ask you to waste time speculating on which companies have these qualities, that's too hard, rather we can crunch some basic numbers to get a better idea.

 

Moat, spelled R.O.I.C.

ROIC (return on invested capital) is the best screening metric I've ever found to pick great stocks that could fend off competition. This metric measures the percentage of total net income (minus dividends) investors earn compared to the capital investors put in. To use a simple analogy, if I paid $100 for my daughters lemonade stand (yes that sounds pricey, blame it on inflation) and she made $50 in profit after all expenses were paid; she could boast that she had a 50% return on capital. I don't really have a daughter, but hopefully my metaphorical one simplified that concept! 

So how does R.O.I.C. spell moat? Well, in the business world, great companies attract competition. Since it's too hard to speculate (guess) if a company is doing something special to retain customers and fend of the competition, we need to rely on numbers. For a business to return a high percentage of shareholder dollars in relation to its total cash it's put in, it’s likely that the business is doing something wonderful to delight its customers.

Using this metric keeps us from being subjective to the companies or brands that only we may love and helps us find some companies we may not have thought of. But, as you'll see in this list of businesses I've compiled with a return on investment over 15% (TTM), many are household names.

Company name

R.O.I.C

Market Cap

Industry

 The Coca-Cola Co. (NYSE: KO)

15.42%

$172.6B

Beverages

 Ford Motor Co. (NYSE: F)

15.75%

$37.9B

Auto/Truck Manufacturing

 Apple Inc. (AAPL)

38.27%

$629.4B

Computer hardware

 Crocs Inc. (NASDAQ: CROX)

21.80%

$1.5B

Footwear

 Guess? Inc (GES)

17.89%

$2.1B

Apparel

 Ralph Lauren Corp (RL)

16.61%

$14.0B

Apparel

 Yum! Brands Inc (NYSE: YUM)

23.44%

$30.3B

Restaurants

 Starbucks Corp (NASDAQ: SBUX)

24.02%  

$37.5B

Retail/Beverages

 Coach Inc (COH)

46.92%

$16.08B

Apparel

You'll notice that I only listed consumer facing stocks; that was intentional. If you're reading this article I have to assume you are worried about inflation (hello!), then, in my humble opinion consumer facing stocks are the best choices for you.

Don't get me wrong there are plenty of business suppliers and vendors that have outstanding returns on capital and are truly great companies. However, when budgets get tight and goods get costly, you won't see a restaurant owner camping outside an avocado supplier’s office for the latest version of guacamole. On the other hand we've seen (much to my amazement) the Apple cult do just that for the latest gadget during the worst recession of our lifetime.

Simply put, businesses will squeeze vendors and consumers will short change goods they view as commodities a lot sooner than they'll give up on their favorite brand. For that reason alone great consumer facing stocks and the moat they typically enjoy (brand loyalty) makes them more likely to be able to overcharge for their goods than other companies can.

It's also worth noting that these companies have a wide range of market caps, which makes a difference. For instance a company like Crocs is a vastly different beast than Ralph Lauren. While Ralph Lauren is larger, more stable and more recognizable, Crocs (arguably) has more room to grow; more market share to capture. You will have to decide which trade-offs fit your investment strategy best.

 

But what's the best value?

It's important that we discuss value in relative terms; one thing that particularly irks me is when investors simply look for low P/E or price to book stocks. If you're worried about inflation, this is not the way to go, we need stocks that have strong growth prospects; the ones that are reasonably priced but still dominating their market. That's why, personally, my favorite value measure (especially for "pricing power" stocks) is Peter Lynch's famous PEG ratio.

For the few who do not know this is essentially a PE ratio which takes growth into account, so a stock with a P/E of 20 with a growth rate of 20 would have a PEG of 1. This stock would be cheaper than, say, a stock with a P/E of 6 and a growth rate of 4. Typically a stock well valued by PEG comes in at or lower than 1. The PEG ratio is often scrutinized because it makes us "guess" or use analysts estimates to figure out what future earnings will be. But this is the case of most growth/value models including discounted cash flow models; PEG is just simpler to follow.

It is worth noting that not all earnings are created equal however; so if you use PEG, before buying, check out the company’s income statement and also ensure it's generating positive cash flow. You'll want to make sure it's creating earnings the right way, from selling more goods, not from selling off assets or tax breaks. Let's take a quick look at our list of high moat companies to see what their PEG ratios are, perhaps we'll find the best of the bunch.

Company

KO

F

AAPL

CROX

GES

RL

YUM

SBUX

COH

PEG ratio

2.69%

0.30%

0.72%

0.67%

0.86%

1.63%

1.58%

1.51%

1.07%

 

Back to Lynch

Unfortunately, one thing I won't do is tell you which of these stocks to buy (sorry), although I think for the most part they all have good future prospects. At some point investing has to get subjective (sorry again) which brings us back to Peter Lynch and his famous "buy what you know" investment strategy.

Lynch has cautioned to make sure to always do the "homework" before buying what you know and we've done some of that. If you're a value hunter, you may want to go with Crocs or Ford who have the lowest PEG multiples (0.30% and 0.67%, respectively). Perhaps you want the company with the strongest moat, well; Coach and Apple provide by far the highest returns on investment and even have the best combination of both R.O.I.C and PEG, to be fair.

But, at the end of the day, you will have to decide which stock you feel most comfortable with and that's where "buy what you know" comes in handy. Which company’s products would you pay up for? Do you need to have that Polo logo on your shirt? Love Yum and their new cantina bowls at Taco Bell? At the end of the day it's subjective but it's the best way to go, because in this volatile market you'll want a stock that you can stick with through a 20% single day decline. If you believe in the product, you're unlikely to sell at the wrong time.

For me, even though its numbers aren't the best in either category, that company is Starbucks. I've never understood how Apple could charge so much more than Dell for its computers, but it does so and is wildly successful. I don't get the appeal of Coach's handbags and I've never worn Crocs but I can't live without stopping at my local Starbuck's for an iced coffee with half and half (no sugar) every morning. I've heard from people who are amazed that Starbucks can charge $4 for a simple cup of coffee but it makes all the sense in the world to me; in fact, I'd pay $5 or $6. To me, and to plenty of others, there is simply no reasonable competitor to get my business. That's real pricing power and that ability matters more to a stock than anything else. When we're lucky enough to find companies that combine both financial metrics along with "buy what you know" we can outpace inflation--by a mile.

 

Summary:

For many of you the metrics discussed in this article probably seemed like "the basics"; that was intentional. Investing doesn't always need to be a guessing game. Sometimes the best approach forward is to rely on simple, time tested metrics to help us find companies that are earning a good return, with good growth prospects at a fair price.

When it comes to an inflationary environment we'll want to be a bit subjective and pick the stocks (after doing the homework) that we believe in, the companies who have products that we'd pay up for. These will be the stocks that can charge more and earn you returns that outpace inflation and you'll need to believe in them in your gut when the winds of change swirl. Because if there's only one thing that the Fed, Congress and even the entire worlds governments have proved we can count on; it's change.

 


Adem Tahiri own shares in Starbucks, Ford and The Coca-Cola Co and has not added to any position within the last 72 hours. He has no plans to add to or sell any of his positions in the next 72 hours. The Motley Fool owns shares of Apple, Coach, Crocs, Ford, Guess?, and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Apple, Coach, Ford, Guess?, Starbucks, and The Coca-Cola Company. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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