Index tracker funds won't shield your wealth from inflation – here's why

How can you shield your portfolio from inflation?

One line that fund managers will often spin you is that you should invest in companies with "pricing power" – if a company can jack up its prices alongside inflation, then what's the worry? You're hedged.

It's a comforting idea. Unfortunately, it's more complicated than that.

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The two questions that really matter when valuing stocks

When you read discussions about inflation and equities, the term "pricing power" is often one of the first things that comes up. The idea is that you invest in companies which can push up their prices in line with inflation. That gives them resilience in the face of rising costs. That sounds logical – and it is logical. However, it's not the whole story. Why not?

Duncan MacInnes of Ruffer has an interesting piece on Citywire, in which he makes an excellent point on equities and inflation, which I'll paraphrase here.

If you really want to boil it down, a share price is dictated by the answer to two questions. The first question is this: what do you expect the company's future earnings to be? Owning shares in a company entitles you to a corresponding proportion of those future earnings. So when you buy a share, you are taking a view on what those future earnings will add up to.

That brings us to the second question. You know what you expect future earnings to be (roughly), but the next question is: what are you willing to pay for those earnings?

This forms the basis of the classic valuation ratio, the price/earnings (p/e) ratio. The p/e ratio simply takes the share price and divides it by earnings per share. So if the share costs £20 and earnings per share are £1, the p/e ratio is 20. The market is willing to pay £20 for each £1 of today's earnings.

And this is where inflation has its real effect, notes MacInnes. Let's say you have a company with solid pricing power; it can shrug off inflation quite merrily, so let's say its earnings stay static in real terms (ie, accounting for inflation). The problem is, during periods of inflation, investors as a group become less willing to pay as much for a given level of earnings. In other words, the p/e ratio tends to fall.

So today, investors might be willing to pay £20 for that £1 of earnings. But as inflation rises, and political and economic risks rise with it, they get worried. By the end of the year, say, the amount they're willing to pay falls to £10. As a result, the share price falls in half even though earnings haven't changed.

How can you protect your portfolio against inflation?

This is a highly stylised example, but it should be pretty clear: an inflationary environment is a riskier environment. In the absence of relative price stability, investors demand a greater level of compensation for the added risk of owning equities. And so all else being equal, equity prices will fall once investors see inflation as something to worry about.

MacInnes illustrates this with the example of Hershey, the US chocolate maker, and how it traded during the 1970s. MacInnes notes that, in the years from 1972 to 1975, Hershey "successfully passed input cost rises onto consumers, so revenue and operating profits grew handsomely". In short, the company did exactly what you'd expect a quality equity with pricing power to do – it kept ahead of inflation to the point where earnings per share rose by more than 65% between 1972 and 1975.

Yet during the same period, the p/e ratio collapsed from 16 to 6, which saw the share price over the period drop by a third (and at one point as much as two thirds). So you can't rely on equities as a group to protect your portfolio from the ravages of inflation.

So what can you do? MacInnes points out that clearly some sectors did do well during inflation. The energy sector is one (it's also doing well right now); commodities is another, and certain financial businesses should do well too. In other words, mostly the things that have been beaten up over the last ten years or so.

It also suggests that passive funds tracking a broad index are probably not going to be the best way to go in a bear market which is driven by inflation.

I'm not saying for a minute that active funds generally outperform in bear markets (they don't) – what I am saying is that investors are going to have to be a bit more picky than a broad tracker if they want their portfolio to survive and even thrive in an inflationary world.

After all, you can get sector-specific exposure with plenty of passive vehicles such as exchange-traded funds (ETFs).

In the latest issue of MoneyWeek magazine – the one out right now – our guest cover story writer, deep value investor Andrew Hunt, looks at oil, and more specifically the oil and gas services sector. Suffice to say, he thinks we're just at the start of a very powerful bull run for this sector, and he runs through several promising stocks across the globe.

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And we'll be discussing the death of the 60/40 portfolio – and what might replace it – at the virtual MoneyWeek Wealth Summit. If you haven't already signed up for that, you really should – I suspect it'll prove to be more than worth the price of entry for that conversation alone.