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06
Jun

Wealth preservation - beating the evils of inflation

Currently, the consensus in the market is that inflation has troughed. Expectations are that higher commodity prices and surges in certain administered costs and taxes will cause the domestic inflation rate to rise – with an increase from the current 4% towards the 6% upper end of the inflation target, or higher. Simply put, inflation means that incomes have to grow much faster than outlays in order to maintain a constant standard of living.

William Fraser of Foord Asset Management says that the preservation of capital in real terms must form the core of investment philosophies if one wants to beat the evils of inflation.

“Investors must select investments that have the ability to grow their values over time.  Such growth comes through increases in the price of the investment (capital growth) and through increases in annual income payments (dividends or interest).  This is particularly true in the present environment, where nominal interest rates are very low, both domestically as well as globally and interest rates are also falling in real terms because rising inflation is not immediately offset by rising interest rates.”

“Interest yields are generally insufficient to cover the risk that inflation will be higher than the market expects.  Therefore, one must seek alternatives to investments in the cash and traditional bond markets.”  

Frasers’ advice to investors is to search for assets on high yields, where the payments are highly predictable, capital is safe and importantly, incomes can grow over time.  “Investments that meet these requirements are often not in traditional interest bearing instruments like the cash and bond markets.  They are therefore often overlooked as options to grow income and capital.”

Inflation beating options

“Listed property instruments have typically delivered returns well above inflation.  In the early part of the millennium yields were attractive and price appreciation has accounted for a large portion of the total real returns achieved over the last decade.  Despite much lower yields compared to 10 years ago, the fundamental approach to listed property as an asset class hasn’t changed,” says Fraser.  “The addition to portfolios of good quality listed property companies with attractive yields increases the probability of producing inflation beating returns.  Annual escalations in rentals of around 8-9% per annum are still the norm in this sector and over time, this growth in rental income should provide for growth in distributions to investors that are above inflation.”

“In the current low interest rate environment, cash flush companies are able to return a significant amount of earnings to shareholders.  Looking forward 12 to 18 months, dividend yields should approach cash rates in many cases.  Importantly, dividends are real, while cash yields are nominal.  Investing in companies that can pass on rising input costs to their customers is important – especially in a rising inflation environment.  Equally important is to trust the management teams of companies to deal with issues like rising prices.”  

According to Fraser, investors should generally seek to support management teams which have dealt successfully with previous episodes of rising inflation.  “Dividends are an important component of total investment returns.  Investing in companies where dividends grow over time provides additional certainty in maintaining one’s standard of living.”

“Growing income from investments is an important component in the wealth creation process. It provides a more certain investment outcome than bonds or cash, where one assumes significant inflation risk.  Listed property with growing distributions and shares with growing dividends are critical to the success of achieving returns which beat inflation. This is particularly true in times when the outlook for inflation is negative and mispriced,” concludes Fraser.

Ends