An ETF for Rising Inflation

by JT on May 12, 2013

Low interest rates are starting to fuel an economic fire. In the financial markets, I believe low-yield alternatives are leading investors to pay up for less attractive dividend funds and junk bonds. (The Wall Street Journal said the same this week).

In the housing market, low interest rates are pushing investors back into single family homes, with prices rising at the fastest pace since 2006. New single family REITs are planning IPOs. On the consumer side, Americans are snatching up automobiles (many of which are financed for less creditworthy borrowers) at a pace reaching 15 million cars per year.

Low rates are bringing higher prices, just in select markets; the markets money reaches first. Past the financial markets, the housing markets, and consumer finance, easy money eventually makes its way into the prices for everything. For all the talk of low inflation, there seems to be plenty of money floating around in the financial markets.

Throwing gold and silver out

Moving a portfolio to position against inflation is often too binary. Many think that inflation must be met with precious metals and their miners.

Gold and silver mirror inflation over very long periods of time, but hardly from year to year, or even decade to decade. Also, mining companies are affected by inflationary pressures. Mining firms essentially trade human labor, energy, and steel into gold. Rising energy or labor prices can easily displace any gains from rising gold or silver prices. Oh, and let’s not forget that silver prices are really just a derivative of copper prices, which are driven moreso by economic development than simple inflation.

A move into bullion or bullion producers is near-sighted at best, nevermind much too concentrated on one industry. It’s time to lay the case for metals to rest. Temporary bull markets in gold make for investing legends, but boom often turns to bust.  For various ways on how to short these precious metals, check out 6 ways to short gold and silver.

Putting equities back in

As much as I believe stocks are fairly-valued, perhaps overvalued in some defensive sectors like utilities, their inflation resilience is unmatched. Some companies are better than others.

One of my favorite ETFs, a fund I continue to become more comfortable with, is a rockstar in the anti-inflationary trade. The Vanguard Dividend Appreciation ETF (VIG) holds very strong, resilient brands, most of which are in the consumer staples and consumer discretionary space, and many of which have pricing power.

Pricing power is all too often overlooked in the hunt for great businesses. It was pricing power that made Berkshire Hathaway what it is today. Munger jokes Buffett’s favorite strategy is buying a business, firing all the employees, and raising prices. He’s not too far off – although that strategy was much more prominent during the early days.

The point is that a brand’s pricing power is what protects its owners from inflation. Buffett paid $25 million for See’s Candies in 1972, invested little more than $30 million since, and pulled more than $1.3 billion from the company’s coffers to date. All of this was done on the back of one annual price increase every single year.

Finding pricing power

A natural place to look would be the Market Vectors Wide Moat Research ETF (MOAT), which holds 20 of the most attractively valued, wide moat companies based on Morningstar’s data. Unfortunately for investors, the fund’s incredible turnover destroys any value in a buy and hold portfolio. Stocks leave too quickly, before their long-term potential can be harvested for profits. The fund has, not surprisingly, underperformed.

Where next? Let’s go back to the Vanguard Dividend Appreciation ETF (VIG). Fund managers have identified companies with long-term pricing power.

Take a look at the list of top fund holdings:

All of these are well-known names, and only two (Chevron and Exxon Mobil) are commodity businesses. Proctor and Gamble owns several billion-dollar brands. Pepsi and Coke own sodas, with Pepsi also leading in chips and snack foods.

There’s pricing power abound in this portfolio. Wal-Mart has scale and the ability to control costs. IBM has a name tech trusts. McDonald’s has the best food at the price point. (Note: at the price point.)

From quarter-to-quarter, brands have no measurable value. All too often are big names hit when slight margin compression results from rising input prices and stable or slow-growing average selling prices. However, over the long haul, leading names have the capacity to increase prices at or above their input costs – and that’s what makes the Vanguard Dividend Appreciation fund the best pick for rising inflation. Not to mention, unlike other dividend funds, its lower yield pushes away current yield chasers, who are driving up asset values in every corner of the market.

These are large cap companies. They’re not going to be to your portfolio what See’s Candies was to Berkshire Hathaway, but when it comes to pricing power, Vanguard’s Dividend Appreciation ETF holds a basket of very exceptional brands. The yield is only a plus, which should help it continue a history of market-beating performance. In an inflationary environment, this fund would hold up extraordinarily well.  It might be best to consult a professional who has completed an mba degree online for advice before investing.

Disclosure: No positions in any ticker mentioned here.

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