2 Stocks To Buy in an Inflationary Environment

Henry Fung - Ausbiz Interview

Henry Fung

Henry is a co-founder of MF & Co. Asset Management with over 15 years of experience as a trader, investor and asset manager. Henry runs the Options Income Strategy and has a free 5-day options income strategy course you can take to learn how to use options to generate income.

June 18, 2021

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Additional points around inflation and the two stocks below.

Supply-driven Inflation Continues to be Problematic

Inflation continues to be driven by the supply side by a commodity bull market and disruptions in the supply chain.

The latest disruption comes in the form of a COVID outbreak at the Shenzhen Yantian port, with the port working at about 30% capacity.

In comparison, the Evergreen blockage at the Suez Canal which lasted 6 days was a 330,000 Twenty-foot Equivalent Unit (TEU) backlog.

The backlog at the port has now reached over 400,000 TEU and still counting.

This has resulted in container fees rising from A$5,500 to over A$15,000 for a Shanghai to London trip.

If disruptions such as this continue to come up, we could see supply-side inflation continue to rise.

On the alternative side, demand-driven inflation can be pro-cyclical.

Whilst supply-side inflation reduces the purchasing power of consumers, demand-driven inflation comes from wage growth which increases purchasing power.

However, we are still not seeing wage growth. In the US, wage growth currently sits at 2%, with the Fed targeting 3.5-4%.

In Australia, even though unemployment has fallen to pre-covid levels, we are not seeing wage growth.

This is why we are seeing the Fed continue to have a dovish monetary policy as driving wage growth to combat supply-driven inflation is the only way to balance out the economy.

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Two Catalysts for Inflation to Stay Under Control

Right now, the Fed is in a sticky situation.

If they continue to print money to drive wage growth, they will also drive inflation up on the supply side.

However, if they become too hawkish too soon, the prospects of wage growth will disappear whilst supply-side inflation continues to rise.

The best case right now would be for two catalysts to happen.

Firstly, the world needs to get COVID under control and global supply chains need to return to pre-COVID levels.

At this point in time, suppliers are taking advantage of a fragile market and charging a premium, knowing buyers will pay overs to hedge disruption risks.

Secondly, we need to see wage growth. With wage growth, the Fed can become more hawkish and reduce the huge amounts of cheap money flowing into the system.

If both of these catalysts can happen, we should see a much stronger stock market supported by fundamentals.

Reduced supply chain pressures mean that companies will have lower production costs and higher wages means more revenue, increasing margins across the board.

Where the Macroeconomic Risks Lie in the Australian Stock Market

There are two main risks right now when it comes to rising rates.

The main risk for the stock market right now is not inflation per se, but what inflation will do to valuations.

Companies are valued on discounted cash flows, which means that they are highly sensitive to interest rates.

With interest rates at all-time lows, valuations are sky-high.

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Any sort of meaningful rise in interest rates due to inflation will see these stocks take a hit.

However, this is more of a US problem as opposed to an Australian problem.

Australia is dominated by miners and banks which are value-based with sensible P/E’s, whilst in the US, a large portion of their market is priced on high growth.

Having said that, stock valuations in general right now are fairly high compared to historical valuations so any rate rises will likely cause some shocks to run through the entire market.

The second risk is our property market. Real Estate inflation is out of control with investors and first home buyers borrowing obscene amounts of money at low rates and paying way above reserve just to get in.

If rates rise from here, we could see a lot of mortgages come under pressure.

Two Stocks to Buy in an Inflationary Environment

Companies that will benefit or survive in an inflationary environment have three key characteristics.

  1. Pricing power – able to set prices for their goods without losing a lot of business
  2. High Return on Equity (ROE) – the real return on equity needs to be positive after accounting for inflation and taxes
  3. Strong Free Cash Flow (FCF) – Maintaining current output will require more cash each year as input costs go up from inflation

Based on these factors, there are two stocks that I think will stand out in an inflationary environment.

Breville (ASX:BRG)

BREVILLE (ASX:BRG)

Breville is a company that sells premium products and can set prices.

With an ROE of 20%, FCF of 67 cents p/share and revenue growth of 16% YoY for the last 3 years, Breville has a strong balance sheet and growth potential.

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Since the COVID outbreak, the world has changed the way it works permanently.

Consumers which have more work from home opportunities demand higher quality home appliances such as coffee machines and cooking appliances, to replicate the quality they are getting when working from the office.

With this in mind, Breville has switched to a high growth strategy, reducing its dividend payout ratio to further expand overseas.

We have written extensively on Breville, read the full research piece here.

Newcrest Mining (ASX:NCM)

Newcrest Mining (ASX:NCM)

Newcrest Mining is a gold mining company.

Gold is a scarce resource traditionally used as an inflation hedge which means it has very good pricing power.

Newcrest currently has an ROE of 11%, FCF of $15.54 p/share and revenue growth of 4.1% YoY for the past 3 years.

Newcrest is a well-established stock with minimal growth prospects and this is reflected in its market average P/E of 22x.

However, what is important with Newcrest is the exposure the stock gives us if inflation takes hold.

If we do see inflation start to get out of control, we should see a new bull market in gold, which in turn will translate to strong revenue growth for Newcrest, making the 22x P/E relatively cheap.

We have written extensively about Newcrest as well, read the full research piece here.

Are you still looking for the best stocks to buy in 2021? We’ve put together a free report on 5 stocks that we think are the best buys on the ASX right now. Download it instantly here.

This is general advice only. MF & Co Asset Management has not considered your personal financial needs, objectives or current situation. This information is not an offer, solicitation, or a recommendation for any financial product unless expressly stated. You should seek professional investment advice before making any investment decision.

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