Inflation Preparation

As a value investor, Charles Bobrinskoy often looks for attractively priced stocks that stand to benefit from an under-recognized risk. Right now, the 54-year-old manager of the Ariel Focus Fund views inflation as the unseen risk lurking in the shadows.

“The stock market pays attention to the short term, and inflation isn’t an immediate concern,” he says. “That’s the reason that stocks of energy companies and others that stand to benefit from inflation are still trading cheaply, and why we think they represent good values.”

After years of trailing the market, fund holdings such as Apache Corporation, National Oilwell Varco and Exxon Mobil saw gains in the 20% area in the first half of the year as energy prices began ticking up. Yet despite the recent run-up, they still have below-market multiples because they lagged for so long. The combination of attractive valuations and inflation orientation makes them a draw for the fund, which has an above-market weighting in the energy sector.

Although inflation will happen at some point, a weak economy has kept prices in check thus far, and there are plenty of signs indicating it won’t be much of a threat in the near future. Since the financial crisis, the Consumer Price Index has risen at only half of its long-term historic average. Gold prices are well below the $1,900 per ounce peak in 2011. Wages are stagnating, making it difficult for people to buy more goods and push up prices. And long-term Treasury yields, one of the first harbingers of rising inflation, are still near historic lows.

Nonetheless, Bobrinskoy thinks the key elements of an inflationary environment and rising interest rates are firmly in place. Thanks to a long stretch of quantitative easing by the Federal Reserve, the money supply has expanded rapidly, a condition that has historically led to inflation. Countries around the world are devaluing their currencies to make exports more competitive, another development that sows the seeds of rising prices.

A recovery in housing starts is also in the cards. “For most of the last 60 years, there have been an average of 1.5 million housing starts a year,” he says. “But for the last five years, that number has plunged to 1 million. There’s a huge pent-up demand here.” His anticipation of a housing recovery has led him to invest in a construction tool manufacturer, Stanley Black & Decker, the fund’s largest holding, as well as in home furnishing retailers Bed Bath & Beyond and Pier 1.

While he characterizes the stock market as “fairly valued to modestly expensive,” he doesn’t believe things are approaching bubble territory just yet. “One of the signs that a bubble is approaching is when investors pour money into equity funds, and that isn’t happening. Another good indicator is newsletter bullishness, and the fact that over half of newsletters are bullish concerns me a little. But I still don’t think that points to a bubble.”

Nonetheless, he still sees many yield-oriented investments as overpriced. That group includes so-called bond substitutes such as REITs and utilities, which investors have bid up to unreasonable levels. Certain corners of the bond market look particularly ripe for a downfall if interest rates rise. “The high-yield market is less attractive than it’s ever been,” he says. “With negative developments in Puerto Rico and state pension systems stretched, municipals are also very risky. And with a 2.5% yield, 10-year Treasury bonds are a return-free risk asset.”