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Summary

  • While inflation hasn't kicked in since the Federal Reserve started quantitative easing, some signs are that it's finally picking up.
  • Warren Buffett years ago laid out a recipe for how companies can beat inflation.
  • Buffett's recipe was quite similar to my Joseph Piotroski-based model's criteria, so the model should be a good place to look for inflation-beating stocks.

Still waiting.

Ever since the Federal Reserve started pumping hundreds of billions of dollars into the financial system nearly six years ago in response to the financial crisis, investors have been waiting for major inflation to hit. And I'm talking big-time investors -- Warren Buffett, John Paulson, David Einhorn and a host of other top strategists have all cautioned about inflation at one point or another in recent years. Yet inflation remains tepid, generally having ranged between a mere 1% and 2% since the crisis, largely because banks have hoarded the cash the Fed was trying to get them to inject into the economy.

But lately some signs have emerged indicating that inflation may finally be heating up. The Institute for Supply Management's Prices indices for both its manufacturing and service sector surveys have been jumping over the last several months, for example.

At some point, inflation will pick up. And, more importantly, even when inflation is low it can eat away at your portfolio -- with interest rates near zero since the financial crisis, that 1%-2% inflation rate has been chipping away at savings accounts, as most Americans know.

So how do you protect against inflation? Well, back in May of 1977 -- just months before the U.S. would see consecutive annual inflation rates of 9.0%, 13.3%, 12.5%, and 8.9% -- Warren Buffett wrote a column for Fortune titled, "How Inflation Swindles the Equity Investor." The thrust of Buffett's piece was that inflation isn't good for any asset class, though he said stocks were probably the best bet in an inflationary period. What really caught my attention, however, were a few of the specific points Buffett made.

The Return on Equity Coupon

While stock returns can vary greatly from year to year, Buffett noted that return on equity for U.S. corporations as a group have been remarkably stable, at around 12%. In a sense, he said, that 12% is like the coupon rate you get on a bond. If you buy the stock market when it is selling at a "normal" level compared to book value, you can expect a long-term return of 12% per year going forward (before inflation and taxes). Buy the market below normal price/book values, and it's like buying a bond below par value -- your returns should be greater than that 12%; buy the market when it's selling at elevated price/book levels, however, and it's like buying a bond above par. Your returns likely won't be as great as that 12% figure over the long haul.

Since stock returns tend to be linked to ROE over the long haul, Buffett made another key observation: For a company to benefit from an inflationary period, he said, it would have to increase its ROE, and that could be done only in one of five main ways:

  • increasing turnover (the ratio between sales and total assets employed in the business);
  • cheaper leverage;
  • more leverage (though he says more debt "should be viewed with skepticism by shareholders. A 12 percent return from an enterprise that is debt-free is far superior to the same return achieved by a business hocked to its eyeballs.")
  • lower income taxes;
  • wider operating margins on sales

Buffett went on to say that he didn't think most companies, or the corporate world as a whole, could do those things with any degree of regularity during an inflationary period. But most companies doesn't mean all companies. Some of Buffett's main ROE conclusions are also part of the method Joseph Piotroski developed some two-plus decades later to identify winning stocks. The Piotroski method may thus offer some hints about individual stocks that have shown an ability to do the types of things Buffett said were necessary to thrive during inflationary times.

Piotroski, whose writings form the basis for one of my Guru Strategies, is a little-known college accounting professor who back in 2000 wrote a research paper showing how using simple accounting-based stock-selection methods could produce excellent returns over the long haul. His back-tested results doubled the S&P 500 over a two-decade period.

Buffett noted that buying stocks with low price/book ratios is like buying a bond below par, and low price/book ratios is where Piotroski's method starts. (Actually, it starts with high book/market ratios, which is essentially the same thing.) Piotroski targeted stocks with book/market ratios in the top 20% of the market -- the type of stocks that Buffett might say were selling "below par."

The Piotroski-based criteria that line up with Buffett's inflation-beating criteria: Asset turnover should be greater in the most recent year than it was a year earlier; gross margin should also be higher; and the long-term debt/assets ratio should be lower. Among the other qualities he looked for: increasing returns on assets and current ratios, and a positive cash flow from operations.

If you're concerned about inflation, stocks passing the Piotroski method may well be a good place to look. Here are three that currently get good scores from my Piotroski-inspired strategy, and a couple that get approval from my Buffett-based approach.

Transocean Ltd. (NYSE:RIG): Transocean is an international provider of offshore contract drilling services for oil and gas wells. My Piotroski model likes its 1.05 book/market ratio, 4.29% return on assets in the most recent year (up from 2.38% the previous year), and rising current ratio (1.91 in the most recent year vs. 1.58 a year earlier).

LG Display Co. Ltd (NYSE:LPL): South Korea-based LG ($10.5 billion market cap) makes displays used in TVs, monitors, notebook PCs, and mobile devices. It has a 0.98 book/market ratio, 1.96% return on assets (up from 0.95% the prior year), a 1.14 current ratio (up from 0.97), and 13% gross margins (up from 10%).

Tata Motors (NYSE:TTM): This India-based auto manufacturer ($22 billion market cap) has taken in close to $40 billion in sales over the past 12 months. It has a book/market ratio of 2.86, and in the most recent year cut an already low long-term debt/assets ratio from 2% to 1%, increased its return on assets from 0.88% to 0.95%, and upped its gross margin from 36% to 38%.

Polaris Industries (NYSE:PII): The Minnesota-based company makes off-road vehicles (including all-terrain and side-by-side vehicles and snowmobiles) and on-road vehicles (including motorcycles and small electric vehicles). The $8.6-billion-market-cap firm has averaged a return on equity of 41% over the past decade, part of why it gets strong interest from my Buffett-based model. The approach also likes that it has increased earnings per share in all but two years of the past decade, and has less debt ($329 million) than annual earnings ($376 million).

Ross Stores (NASDAQ:ROST): This California-based discount clothing apparel and home goods retailer operates under the Ross Dress for Less and dd's DISCOUNTS names. It has taken in about $10 billion in sales in the past year. The Buffett-based model likes that it has upped EPS in every year of the past decade, has a 10-year average return on equity of 33.5%, and has just $150 million in long-term debt vs. $839.5 million in annual earnings.

Source: Buffett, Piotroski, And An Inflation-Beating Approach