The best stocks to own when inflation is rising

Investors have three enemies: fees, taxes, and inflation. The first two are clear, so most of us do our best to reduce brokerage expenses and fund fees while building our portfolio in the most tax-efficient way possible. Inflation, however, is subtle, it's pernicious, and slowly chips away at our purchasing power. We barely give it a second thought.

In a classic piece for Fortune, Warren Buffett wrote: 

'The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5% passbook account whether she pays 100% income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5% inflation. Either way, she is "taxed" in a manner that leaves her no real income whatsoever.'

Stocks tend to do poorly as inflation rises, and do worse if it rises rapidly. From 1970 to 1974, inflation tripled to more than 15% in Australia. Over that time, Australian stocks declined 60%.  

Thankfully, inflation has settled down since then. Today's inflation rate is only around 2%. However, it's been gradually rising since the decade-low of 1% set in mid-2016. A 1% difference doesn't sound like much, but for assets yielding, say, 6%, your real return is 17% lower than it was a couple of years ago. 

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If inflation spikes, all stocks are affected negatively, and especially those where inflation causes a company's costs to grow faster than revenue, which erodes its profitability. However, some companies can handle inflationary shocks better than others and so tend to outperform (so long as you don't pay too much for them). Almost always, it's where the business possesses two qualities: limited capital expenditure requirements combined with the ability to raise prices.

1. The obvious choice is any company where revenues are directly adjusted for inflation due to Government mandates. Toll road operator Transurban (ASX: TCL), for example, is able to raise its toll prices in-line with inflation, and sometimes more. 

2. Other monopolies where the infrastructure is already built, such as Sydney Airport (ASX: SYD) or oil pipelines, are also protected as they have an easier time raising prices because their assets are difficult to duplicate. 

3. Stocks with strong brands and low capital expenditure requirements also tend to do well - think the banks, Seek (ASX: SEK), or REA Group (ASX: REA). These companies produce plenty of free cash flow and don't need to spend a lot each year on upgrading factories and equipment. If they can raise prices due to competitive advantages, it means they can earn higher returns on their existing capital base. 

4. Finally, real estate investment trusts, such as Scentre (ASX: SCG) and Goodman Group (ASX: GMG). Anything with tangible assets in limited quantities (such as land) will tend to see their valuations rise, though this may still be below general inflation for goods and services.

At its core, inflation doesn't only affect your purchasing power, it can erode a company's profitability too. Buying high-quality companies when they are undervalued and then holding them for the long term doesn't guarantee that you will beat the inflation taxman, but you'll do far better than owning most other assets or holding cash. 

Note: None of the stocks listed above are currently on our Buy list. For a list of stocks we consider undervalued in today's low-inflation environment, see our current recommendations.