This article is excerpted from Tom Yeung’s Profit & Protection newsletter dated July 21, 2022. of Tom’s picks, subscribe to his mailing list here.
Finding stocks that will survive high inflation is more complex than it seems. Energy and basic materials prices – traditional inflation hedges – fell on concerns about sagging consumer demand. Retail investors are rushing into companies like Indonesian Energy Company (INDO) and American Energy Corporation of Houston (HUSA) saw their positions nearly wiped out.
Meanwhile, high-growth tech companies fare no better. Companies of Expedia Group (EXPE) at Coinbase (PIECE OF MONEY) are seeing stock prices plummet as clients tighten their belts and close their wallets this year.
When inflation is accompanied by an economic downturn, the resulting “stagflation” tends to hit all industries.
Yet some classes of stocks tend to survive…and even thrive…thanks to rising prices.
Some of these companies are benefiting from higher demand. Discount retailers like Costco (COST) and General dollar (CEO) are natural substitutes for customers trying to maximize every dollar. Social media and mainstream news outlets are now salivating over Costco’s $4.99 rotisserie chicken.
Other companies use financial or operational leverage to turn rising prices into a windfall. If an egg producer’s break-even cost is 90 cents per dozen eggs, a 50% increase in wholesale prices from $1.00 to $1.50 results in a 6-fold gain for the producer (profit increases from $0.10 to $0.60). It should surprise no one that the egg farmer Cal Maine Foods (CALM) is up 40% over the year.
These companies tend to perform best during early recessions. However, as inflation continues, demand for rotisserie chickens and eggs will also slow. 2008 Recession Winner Award McDonald’s (MCD) recorded losses during the second half of the financial crisis.
Investors looking for more all-time inflation winners need to look further to the second-order winners. And a class of shares has everything to gain, regardless of the economy:
Community and regional banks.
Banking stocks: the second-order winners
The banking sector has long benefited from rising interest rates. Banks can take customer deposits (currently averaging 0.03% interest per annum) and deposit them with the central bank for higher rates. On Friday, the prevailing interest rate on reserve balances (IORB) climbed to 1.65%, its highest level since the start of the pandemic.
The difference between these numbers is known as the net interest margin (NIM). This is how most banks make money and why community banks like CVB Financial (CVBF) saw shares ascend This year. When the Fed raises interest rates to fight inflation, these companies naturally benefit from larger NIMs.
Banks that invest in higher yielding assets such as treasury bills and treasury bills also benefit. My first banking choice Charles Schwab (SCHW) derives more than half of its income from interest on federally backed mortgages; analysts expect Schwab’s net interest income to rise 30% this year.
A word of warning
However, not all banks are winners from stagflation.
Companies like Capital one (COF) earn interest on credit cards, while those like Allied Financial (ALLY) do it from car loans. An economic downturn can quickly send these companies’ loan losses spiraling out of control, as mortgage lenders discovered in 2008. Poor underwriting standards will do the same.
Investment banks are also at risk from a broader economic downturn. This week, Goldman Sachs (GS) joined other mid-sized banks reporting bad news: Investment banking revenue fell 41%, though that’s slight compared to a 55% drop in Morgan Stanley (MRS) and the drop of 61% to JP Morgan (JPM).
In other words, investors looking for inflation protection need to find:
- Stable NIMs. Conservatively managed banks with a history of minimal loan losses in times of crisis.
- Moderate revenue growth. Mid-growth financial companies outperform their faster-growing counterparts (The Benefit & Protection the system considers that too rapid growth is an alarm signal)
- Positive profit and protection scores. Growing momentum and solid capital returns at a reasonable valuation.
5 stocks to buy when inflation rises
Fortunately, smaller banks tend to do the trick. These firms lack the trading, investment banking and personal lending businesses that define more cyclical banks.
And while they all run the risk of hiding bad debts (since modern GAAP accounting principles are weak at detecting problems), an investor who buys a basket of these conservative stocks will profit even if inflation rages.
- FinWise Bancorp (FINW). A Utah-based fintech bank focused on SBA-backed loans. The company achieves net interest margins of 15%, which translates into a return on equity (ROE) > 30%. A price-to-book ratio of 1.5x provides some breathing room if his lucrative (though sometimes questionable) partnership business were to falter.
- Bank7 Corp (BSVN). An Oklahoma-based community bank with an eye on cost control. This company’s efficiency ratio of 36% is much better than the benchmark of 50% used by most banks, leading to a 2x to 3x higher ROE.
- First Citizens BancShares (FCNCA). A recent merger with CIT Bank in January created this $100 billion juggernaut with significant savings potential. Analysts expect the bank’s efficiency ratio to drop from 65% in 2021 to 54% by 2023.
- CVB Financial (CVBF). A Southern California bank with a history of low loan losses and top-notch efficiency ratios. CVB’s focus on secured commercial real estate loans provides the company with strong downside protection.
- Citizens Financial Group (CFG). A North-East regional bank with 900 branches. The company is growing more slowly than most community banks due to high costs, but Benefit & Protection thanks to its exposure to rising net interest margins.
- PNC Financial Services (ANC). A well-run bank that has completely changed since the 2008 financial crisis. The company has since acquired National City and RBC’s US branch network to become the second largest regional bank in the US. Analysts predict double-digit growth in net interest income over the next few years.
Community Banks: The Hidden “Protection” Investments
It is easy to forget about community banks. These slow-growing companies rarely make the headlines (unless you count American banking magazine).
Yet not only do these companies outperform inflation, they thrive in rising rate environments. When rates increased between February 2016 and 2018, the SPDR S&P Bank ETF (KBE) rose 80%, beating the broader S&P 500 (40%) and even tech (60%).
The best financial companies are also Perpetual ticket machines. Insurers like Warren Buffett Berkshire Hathaway (BRK) and banks such as American bank (USB) convert 20% of ROE into book value growth. A decade of 20% growth rates increases a company’s value sixfold, thanks to the magic of compound interest.
This is why these companies continue to occupy a place on the Benefit & Protection watch list. When looking to hedge your earnings against inflation, it pays to keep some high-quality banks in your back pocket.