Fighting Inflation: The Merits of Gold and Pricing Power

By Gabe Farajollah

Many economists and investors are predicting widespread inflation, following the
trillions of dollars of stimulus recently pumped into the economy. As a result, in this post
I look at the merits of investing in gold and companies with pricing power as hedges
against a weakening U.S. dollar.

Led by Warren Buffett, value investors

are largely known for relying on
"bottom-up" fundamental analysis to
make their investment decisions. They
often shun those who try to predict
macroeconomic events, which are
dependent on countless factors and
difficult to time correctly. Yet recently,
a handful of famous investors such as
David Einhorn have realized that "it isn't
reasonable to be agnostic about the big
picture" and that doing so "doesn't mean
abandoning stock picking." After all, the
U.S. government has pumped trillions of
dollars of stimulus into the economy and
there is a good chance that there will be some serious long-term effects. One train of
thought gaining a great deal of popularity is that legislators will continue to keep the
printing presses running for a number of reasons, such as their unwillingness to raise
taxes or cut expenditures, which would hamper their chances of reelection, and the
possibility that they can payoff the country's mounting debt with newly minted, cheaper
dollars. While future inflation is no sure thing, investors around the world have taken
notice, as the price of an ounce of gold is currently $1,114 and the yield curve has
recently steepened to record levels. How can investors protect themselves from inflation?
In his most recent memo, Howard Marks, the Chairman of Oaktree Capital, offered
eleven ways to do so. Although all of these options should theoretically work, I am going
to take an in-depth look at two opportunities that offer particularly interesting risk-reward
characteristics: buying gold (or the securities of business that own gold) and investing in
companies with pricing power.

Historically, there has been a strong negative correlation between the value of the U.S.
dollar and gold; as the dollar weakens, gold appreciates and vice versa. With this in mind,
a handful of investors have reasoned that since inflation typically follows an increase in
the monetary supply, our currency will weaken and there is the possibility that gold, to a
certain degree, will supplant the U.S. dollar as the world's preferred reserve currency (see
India's recent $6.7 billion purchase of gold from the International Monetary Fund). If this
does not happen, many think that the demand for gold should at the very least increase
from its levels today. To take advantage of such a phenomenon, several fund managers,
such as David Einhorn, have purchased the commodity and opted to pay for its storage,
rather than buying gold ETFs such as GLD, which have a costlier expense fee. Yet, as a
value investor, I am somewhat hesitant to invest directly in gold, as I cannot determine
what it is worth and thus purchase it with a margin of safety. Remember, an investment is
theoretically worth the present value of future cash flows; since gold has minimal
fundamental purpose and yields no money it is difficult to assign it a definitive value.
One alternative to this is to invest directly in companies, such as miners, which stand to
profit from an increase in the price of the commodity. This is precisely what John
Paulson is doing with the recent launch of his gold-only hedge fund. However, one must
realize that even deriving a value for such companies is somewhat speculative, as their
expected profits are largely dependent on the price of gold. All in all, most gold related
investments carry a risk that is tied to the future amount that people are willing to pay for
the commodity.

Another method of safeguarding against a weakening dollar, which has received

relatively less attention recently, relates to investing in the equity of companies that have
pricing power. To understand why this is true, investors must first comprehend how
equities are affected by inflation. In Benjamin Graham's Intelligent Investor, he
concluded, "The only way that inflation can add to common stock values is by raising the
rate of earnings on capital investment. On the basis of the past record this has not been
the case." Warren Buffett has agreed with this statement, by likening common stocks to
fixed income investments because of their consistent return on equity, even in the face of
inflation. Although the overall market's return on equity capital has risen in recent
decades, due to increased leverage, higher turnover and wider margins, it is unlikely that
this trend will continue and thus the few enterprises that can further increase their
margins stand to benefit the most. As Bruce Greenwald, the Director of Columbia
Business School's Heilbrunn Center for Graham & Dodd Investing, notes, companies
with pricing power are attractive because they "can pass along inflationary price
increases" and "are not subject to
competition from excess capacity."
Therefore, to profit, investors should look
for businesses, similar to Microsoft, Intel
and Coca-Cola that operate like a monopoly
or have a durable competitive advantage.
Such companies can be identified by
examining various commercial landscapes,
as well as screening for stocks that have high
returns on assets, equity and invested capital,
among other metrics (to learn more about
this topic, I recommend reading Warren
Buffett's letters to Berkshire Hathaway
shareholders and Bruce Greenwald's
Competition Demystified.)

Fortunately, large organizations with wide economic moats have not appreciated as much
as smaller companies because investors have recently opted for riskier and more cyclical
assets. As Greenwald points out, currently "the best bargains are in franchise businesses,"
as they are providing "8% to 11% and in some cases 13% to 14% sustainable earnings
returns." As for gold, although it is trading slightly below its peak price of $1,227.50, it is
rather inexpensive in terms of historic inflation-adjusted numbers, which translate gold's
$873 per-ounce price in 1980 to above $2,200 in today's dollars. So which investment
strategy is preferable considering the price of gold and equities today? While there is no
definitive answer, strong cases can be made for adding a moderate amount of both to
one's portfolio. Companies with pricing power should appreciate regardless of the
macroeconomic environment, and gold, despite being hard to value, has typically been
one of the best hedges against inflation.