STRATEGIES TO DODGE INFLATION

WAHAJ ASLAM
(feedback@pgeconomist.com)

Aug 2 - 8, 2010

"Inflation is when you pay fifteen dollars for the ten dollar haircut you used to get for five dollars when you had hair." - Sam Ewing.

Inflation is investor's worst enemy. It eats into the real purchasing power of an investor. Over any given time period, a portfolio's return needs to equal the rate of inflation just to preserve the purchasing power the investor started with. Only when the return exceeds the rate of inflation does the portfolio start to generate any increase in the purchasing power.

The first step to protect yourself from inflation is to enroll in a Systematic Investment Plan (SIP) this is a vehicle offered by mutual funds to help investors save regularly for accumulation of wealth in a disciplined manner over the long-term. Investments made through SIP can be invested in equity, money market or balanced funds in order to earn positive "inflation adjusted returns".

There is a common misconception that saving accounts at banks can help investors accumulate wealth over the long-term. These accounts offer a meager return of five per cent, which does not compensate for the inflation levels in Pakistan. Savings certificates/term-placements and bonds do slightly better but not by much. So what an investor is to do? Following are some of the options at hand

SHORT-TERM MONEY MARKET FUNDS

Whenever there are inflationary concerns, it may be best to keep your money in short-term accounts or money market funds which provide market based returns, or in other words floater returns. This is because money market funds invest in short-term money market instruments and in case of higher inflation expectations, it is soon followed by higher interest rates as well which are transferred to the investor instantly as the portfolio adjusts instantaneously. This provides an opportunity to enjoy market based returns and an opportunity to lock-in long-term high yielding instruments when the interest rates have peaked or are in a comfortable zone.

STOCKS/EQUITIES

Stocks, unlike bonds, provide a variable income. Stock represents ownership of a business, and a stock's value depends, in broad terms, on the success, or lack thereof, of the underlying business. Investing in quality, blue chip stocks has traditionally been the best long-term way to beat inflation. The only problem is that if inflation becomes a major impediment to economic growth, the stock market will most likely suffer too. One way to reduce that risk is to stick with big, blue chip companies which, by virtue of their size, have more pricing power than small companies. Moreover, these companies often pay out dividends which, in contrast to investing in fixed-income investments, should provide a reasonably good long-term inflation hedge because earnings grow on a nominal basis and investors retain exposure to economic performance. Any share price gains are simply a bonus on top of the payout increases.

COMMODITIES

Oil/Gold - commodities are categorised as "real assets" and are considered a better way to protect one's capital from inflation. Investing directly in commodities has not been a real option for Pakistani investors as no avenue to trade them was available. However, with the recent launch of "National Commodities Exchange", commodities are expected to become a regular part of portfolios. Crude oil prices have provided a 14 per cent per annum return over the last 10 years, once again beating the average inflation rate during the same period. Similarly, gold prices have yielded 12 per cent pa during the last 10 years and investing directly in the gold bullion has been a popular investment avenue in the past. Commodity investments can also be made through commodity mutual funds which help manage risks better, however these funds are not readily available to Pakistani investors yet.

Commodities and equities generally complement each other's performance during different phases of the economic cycle. When inflation is high, commodities are the best performers while the performance of equities is relatively subdued due to high interest rates. Alternately, equities are the best performers when inflation is low as it is accompanied by low interest rate; however performance of commodities is subdued in this phase. Therefore it is a good idea to have a mix of equities and commodities in a portfolio in order to generate stable returns across the economic cycle.

TOP DIVIDEND YIELDING STOCKS

COMPANY DIVIDEND YIELD
Hub Power Company 16%
Kot Addu Power Company 14%
National Refinery 14%
Fauji Fertiliser Company 13%
Fauji Fertiliser Bin Qasim 13%
Pakistan Petroleum 12%
Pakistan Oilfields 11%
National Bank of Pakistan 11%
Attock Petroleum 10%
Shell Pakistan 9%

The table shows a list of stocks which offer an attractive dividend yield. Hubco has been a long-term market outperformer on total return basis. Since its IPO in 1994, Hubco has provided a total return of 16.5 per cent pa, outperforming KSE-100 return of 10.4 per cent pa during the same period and also beating inflation (average inflation since 1994: approximately 8 per cent pa) by a significant margin.

REAL ESTATE

Real Estate is also categorised as a "real asset" and has been traditionally considered a good hedge against inflation. The large transaction size and limited liquidity are significant obstacles for small investors looking to enter into this asset class. Small investors can access the asset class through Real Estate Investment Trusts (REITs), which are essentially a securitised version of direct ownership (with a management company providing the actual investment decision making and day-to-day operations). REITs are currently not available in Pakistan, however regulations are being streamlined by the Securities & Exchange Commission of Pakistan, and REITs are expected to be launched shortly thus providing an alternate investment opportunity to the investors.

CONCLUSION

Inflation is considered to be a monetary phenomenon under the Milton Friedman school of thought. It is the result of central bankers not being able to adjust the monetary policy perfectly inline with the ever changing economic dynamics. However, the nature of inflation is different every time and no single asset class provides the ultimate shield against adverse effects of this phenomenon. Therefore, it is recommended that investors create a suitable mix of the asset classes discussed above to enjoy benefits of diversification as well as build real purchasing power over the long-term.