Why you can't forget inflation

By Pat Dorsey, director of equity research for Morningstar


(Money Magazine) -- Now that Europe's financial markets have hit a giant speed bump, raising fears that the U.S. recovery could also stall, inflation probably isn't something you're worried about today. But when it comes to the threat of rising prices, there are a couple of things you should know.

The first is that the planet's smartest investor is worried about inflation. I recently had the pleasure of attending the annual meeting of Berkshire Hathaway in Omaha. Normally at these events, Warren Buffett balks at making broad macroeconomic pronouncements -- he once called economic forecasts a "distraction" for investors. But this time the Oracle of Omaha came out and said "the prospects for significant inflation have increased, not only here but around the world."

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Pat Dorsey is the director of equity research for Morningstar.

Did he predict when inflation would rear its ugly head? Nope. But the other thing you need to know about inflation is that if you wait until steep price jumps actually show up in the economy, it will be too late and costly to protect your portfolio.

The question is, What strategies should you undertake to combat inflation? The knee-jerk reaction is to buy gold or other "hard assets." But here again, I like to take my cues from the master, who prefers to fight inflation by investing in shares of companies with pricing power.

This makes sense: Businesses with a strong enough competitive position to hike prices can handle rising inflation easily. By contrast, weaker players that can't pass along increases for fear of losing sales have to absorb these costs, putting the squeeze on their profits.

Many companies with pricing power happen to be among the market's biggest in terms of market capitalization. And these mega-size firms, happily, offer great values because they didn't rebound as much as other stocks last year.

You can invest in them through an ETF like Vanguard Dividend Appreciation (VIG), which is full of behemoths like Johnson & Johnson (JNJ, Fortune 500). There's also a different type of fund, called the ELEMENTS Morningstar Wide Moat Focus ETN (WMW), which tracks an index of undervalued firms that, according to Morningstar, have strong competitive advantages (we refer to this as having a wide economic moat).

As far as individual stocks with pricing power, you've got several options. You can go with those that sell products that dominate the competition, like cigarette maker Philip Morris International (PM, Fortune 500). Or you can stick with companies whose sheer breadth of offerings swamp the competition, like the semiconductor equipment maker Applied Materials (AMAT, Fortune 500). Or check out Paychex (PAYX), a payroll processor for smaller businesses that loathe the hassle of switching services too frequently.

All of these stocks are trading at least 20% below Morningstar's estimate of their true value. What's more, all of these companies create value by selling products or services that customers want or need -- as opposed to gold, which creates value by being shiny.

Do you have an 800-plus credit score? Or have you pulled your score up past 700 after a financial setback? If you'd like to talk about it for an upcoming issue of MONEY magazine, send your name, age, phone number and a few details about your story to imangla@moneymail.com. To top of page

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