Three Ways to Tame Inflation Rising prices have investors scared. This trio of strategies should help you
By Stephen Gandel

(MONEY Magazine) – From the grocery aisle to the gas pump, inflation seems to be creeping back. So far, it's still low in absolute terms--around 3%. And there's a lively debate among market watchers about how fast inflation will climb from here. But fear of rising prices has already helped put a damper on the bull market that took off last year. That's reason enough to pay attention to inflation risk now.

Why is inflation bad for stocks? On the face of it, equities seem like the place to be in times of rising prices. After all, inflation usually occurs because the economy is zipping, so consumers spend more and are willing to pay higher prices. That ought to mean higher profits and climbing stock prices, no? Actually, no. For one thing, inflation means that companies have to pay more too--for everything from raw materials to office furniture and, eventually, wages. And as long as they have fierce competitors, some firms can't raise prices fast enough to compensate for their rising costs.

What's worse is inflation's effect on future earnings. Remember: When you buy a stock, you are buying a claim on a company's profits down the road. When inflation rises, those earnings aren't worth as much in today's dollars, so logically you would be willing to pay less for a stock. Unfortunately, everybody else in the market can do the same math.

But not all companies are losers when prices climb. Many are immune or will actually benefit. On the next page we'll show you three ways to protect your equity portfolio from inflation. Or even just the fear of it.

1. Companies that track inflation

When inflation fears abound, many investment pros add mining, energy and industrial stocks to their portfolio. Call it the "if you can't beat 'em, join 'em" approach. At the beginning of an economic recovery, demand for basics like oil, steel and paper tends to be greater than supply. Until supply catches up, producers can raise their prices.

But commodity producers' fortunes can change rapidly. When the economy slows, some find that they've produced too much. Prices and profits fall quickly. If you don't want to try to time these turns in the market, consider leaving the decision to Charles Ober, the seasoned hand at T. Rowe Price New Era (PRNEX) fund. New Era is more diversified than the average natural resources fund (50% of the fund is in energy stocks vs. 75% for rivals) and holds some stocks that don't rise and fall with the economy. Right now Ober likes paper and fertilizer companies. Since he took over in 1997, New Era has returned 8% annualized.



Note: As of May 28. Source: Lipper.

2. Companies that benefit from inflation

Tractor manufacturer Deere & Co. (DE) dominates a market that picks up when inflation is rising. Grain prices are increasing, helped by both the strengthening U.S. economy and accelerating demand from China. Farmers actually find it easier to borrow money when the economy improves, because higher crop prices (and increased land values) provide additional collateral. Flush farmers with good credit equals higher demand for tractors.

And nobody sells tractors like Deere. "It's the General Motors of the farm machinery business," says John Stark of Stark Research in Chicago. In 2003, 41% of all tractors and combines sold in the U.S. were made by Deere. The company's network of 3,200 dealers, which makes its tractors easy to buy and maintain, bolsters that industry dominance. And Deere is flexing some muscle: It has raised prices by 3% this year. At a recent $69, the stock trades for just 14 times expected 2004 earnings.


PRICE $69 P/E 14 52-WEEK RANGE $44 to $75

Notes: As of June 24. P/E based on 2004 estimates. Source: Thomson/Baseline.

3. Companies that are immune to inflation

Brands matter. Companies with a recognizable and trusted moniker are worth more than the net value of their assets because they have pricing power--that is, they can get people to pay more for their goods. Motorcycle maker Harley-Davidson (HDI) is a prime example. Last year Harley made 301,121 bikes and sold every one of them. It wasn't a fluke--their bikes have been selling out for the past decade. Profits at Harley reached $2.50 a share last year, and this year analysts expect $2.87.

Earnings should grow nicely from there. Harley has completed construction on a new plant that will increase the number of bikes it makes to 400,000 by 2007. And there is little danger that Harley will have to cut prices to empty the showroom. Todd Griesbach, an analyst at the Columbia Acorn fund (which owns Harley shares), thinks the company will be able to raise prices faster than inflation for a long time. "People who want a Harley have to pay a premium to get one, and they will," he says.


PRICE $61 P/E 21 52-WEEK RANGE $38 to $62

Notes: As of June 24. P/E based on 2004 estimates. Source: Thomson/Baseline.