While some investors may argue that when dealing with equities it is important to diversify your portfolio in different sectors combating one another so you do not obtain high capital losses. While the statement may be true in times of volatility, during inflationary periods such as the one that is cautiously approaching and worrying the Federal Reserve, I would recommend avoiding such mutual fund tactics and encourage the purchasing of inelastic stocks.
When I mention the word inelasticity I am referring to how much a certain quantity of goods or services demanded or supplied will change relative to the change in price. Typically when you see prices rise due to inflation, quantity demanded for a particular good such as a car or computer will decline. Now the key for this report is how much will the quantity of that good will decline in terms of a percentage. If the percentage is larger than the change in price, the good is said to be elastic meaning it is volatile in terms of price fluctuations. However, if the percentage of that quantity supplied or demanded is less than the change in price, the good or service is said to be inelastic, taking little to no heed if prices increase. Typically if a good or service is inelastic profits and revenue will bolster during periods of inflation while elastic goods or services will suffer.
Now what does that mean in relation to equities? During inflationary times a company that produces an inelastic good or service will see its revenue, operating margins, net profits, and production usually increase making such a stock desirable to buy juxtaposed to an elastic based company. If these figures ascend creating great cash flow, optimistic future guidance, and increased earnings, a certain inelastic company will be in good position to appease shareholders. While an inelastic producing company may experience some growth typically during inflation the rest of the market may experience lower than expected values creating capital losses.
So what types of sectors should you look at in relation to this inelastic wonder? Probably in times of inflation the best area would be consumer staples and healthcare. Both areas produce goods and services which are required by some of their consumers regardless of their price. Good options would be large capitalization companies such as Coca-Cola, Pfizer, Altria, and Procter & Gamble. All of these companies produce goods such as soft drinks, medicines, cigarettes, and household necessities such as toothpaste which will rarely be affected in terms of quantity demanded if prices rise. If toothpaste, for example, rose one dollar from $3.00 to $4.00 more than likely the average consumer will not stop his or her purchase of toothpaste even with a 33% increase in price because this product is a necessity and worth the sacrifice regardless of price. Returning to equities, statistically all of these companies have done well during earlier periods of inflation, and because they are all low risk stocks with relatively small betas there should be a strong optimism concerning capital gains during an inflationary period.
Sectors that should be avoided during times of high prices are found in technology and retail. Companies such as Dell, Nike, and other corporations found in these sectors typically do not have great capital gains if any during periods of inflation. Since prices have increased for many goods, a bigger portion of a consumer’s income (especially fixed income) will be going to the necessities such as toothpaste while at the same time sacrificing other luxury goods such as new high-tech computer or brand named sneakers. The unfortunate effect is that companies such as Dell will post lower earnings and revenue creating capital losses for its shareholders.