Asset-Light Inflation Hedges

Investment Thesis

I have been looking for alternative inflation hedges so as to mitigate the risk of potential problems with TIPs. Ideally, I have been looking diversify to areas outside of the Real Asset Category, which is my other source of inflation protection.

Funds held in my Multi Asset portfolio have large holdings of TIPs to protect against inflation. One concern I have is that if the CB loses control, they will change the measure of inflation so as to stay under the target. Jim Bianco noted that recently the Fed had recently bought more TIPs than were issued, and now have an enormous footprint (~21%) in the market and the ability to manipulate the rates, “It no longer measures, it is now targeted”. They might not offer the expected protection.

In this video Andy Parker of Horizon kinetics states that he thinks TIPs fail as an inflation hedge for 2 reasons. Firstly, that they are a bet on inflation rather than a hedge, for TIPs to have a +ve rate of return inflation needs to be high. Secondly, TIPs underestimate the rate of inflation as they use CPI which understates inflation, so the bet is not well placed.

In this interview, Russell Napier discusses financial repression and his expectation that over a prolonged period, the governments will peg rates near zero with actual inflation being much higher. He mentions how this repression may be at the institutional level, rather than personal level and raises the prospect of forcing financial institutions (funds!) to buy government bonds. In order to do this they would be forced to sell equities, leading to prolonged equity underperformance. His thoughts are that it is possible escape the repression by identifying companies that would benefit in an inflationary environment, even if more generally the equity performance is poor. He specifically mentions companies with fixed costs, emerging markets, gold and residential real estate.

Many companies viewed as offering inflation protection such as oil companies do not perform well under an extended period of inflation. These companies are asset intensive and although they initially benefit, their fixed costs and operating costs increase which causes profit margins to contract. Speaking more generally, many companies experience poor returns in inflationary environments as many costs cannot be passed on. In addition, PE ratios also contract leading to poor performance eg MCD 1973->1979 the PE went 75->10 despite 25% earnings growth.

Asset Light

There are alternative ‘Asset-Light’ companies, that can perform well regardless economic circumstances, and benefit from indirect exposure to inflation drivers. These companies typically have low fixed costs (eg few employees) which would not increase by much in an inflationary environment.

Horizon Kinetics noted many companies will suffer margin compression, with a primary cause being due to employees requiring their salary to match inflation. Companies will need to increase salaries above inflation to have an (after tax) take home pay increase matching inflation. Assuming salaries start to fall into higher tax brackets, significant increases would be required. This squeezes their margins and makes them less profitable. Asset light business often have fewer employees, and so don’t suffer the same problem.

The asset light business creates lots of excess cash that can be re-invested. These companies usually provide a product or service that is not widely available or easily reproducible. They have pricing power, in an inflationary environment they have the ability to increase prices without their costs increasing, resulting in margin expansion. Importantly, they are not a bet on inflation: they do NOT require an inflationary environment to prosper. Exactly the type of company Russell Napier was discussing above.

Method

Security Exchanges

Security exchanges could be considered counter cyclical, providing essential economic infrastructure. They can be thought of as operating a quasi-monopoly, it is difficult for new entrants to establish scale / volume, meaning there is little competition between exchanges. Operating expenses are low and fixed. Many have strong balance sheets.

Security exchanges can perform well in any environment. In a stable environment, they benefit from new listings, trading, data provision. In a volatile environment (2008) trading volumes increase significantly as firms need to hedge (eg interest rates, commodities, etc) along with a general increase in speculation. It is instructive to view the performance during the 2008-09 period.

“Counter-cyclicals benefit from market conditions with more volatility and wider transaction spreads, which have been suppressed in this artificially low interest rate environment. These provide an entirely different way to try to benefit from conditions that can initiate an otherwise injurious future equity market.”

Links

Lawrence Hamtil 1
Russell Napier 1

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