In today’s issue:

  • Should defensive investors flee into cash? No
  • Bonds? No
  • They should rotate into basic industries and dividends

Yesterday I wrote about how rising interest rates and widening credit spreads could lead to a stock market correction or even a crash.

Today, I’ll tell you what to do about it.

Should you buy bonds instead?

Sell up and flee into cash?

No and… no.

Let me explain why… Inflation is currently at 2.5% compared to this time last year. Given the recent rise in oil prices and drop in the pound, it’s likely to head higher again.

Especially if we assume Labour will try to borrow and spend their way to prosperity.

This means that bonds and cash will lose value in real, purchasing-power terms over the coming years.

What then is the defensive, inflation-aware, savvy investor to do?

To put it simply: rotate within the stock market rather than rotate out.

Stay invested, but only low on the value chain. As with limbo dancing, get as low as you can.

What do I mean by “low on the value chain”?

Let’s start with commodities. That is, raw economic input. All industrial processes must begin with raw inputs. These need to be gathered, refined, chemically and/or transformed, and processed.

To do that, it requires some mix of industrial technology, energy, labour and capital. That includes plant, property and equipment to carry out the processes. Even if it’s only a basic process, it contributes to producing the output.

This is where valuation multiples are usually lower.

Perhaps most important, this is the part of the economy least distorted by inflation. It’s also where it’s easiest to pass price increases through to customers, protecting profit margins.

The output of the lowest value chain firms might itself be a low-level input. Yet it’s essential to other basic or more advanced industrial processes.

Consider sulfuric acid. It has almost no household use. (Indeed, you shouldn’t have any lying around, as it’s dangerous, nasty stuff.)

However, it’s arguably the single most important industrial chemical when measured in terms of the overall amount of activity it enables. Most critically, in fertiliser production.

Much of the chemicals industry sits relatively low on the value chain. Recall the classic 1960s film The Graduate. There is a scene in which a young university graduate who’s unsure what career to pursue speaks with an older, successful businessman who recommends that he get into “plastics”. (Plastics are part of the petrochemicals industry.)

What chemicals and other, basic industrial products have in common is that they are essential to economic life as we know it.

It’s true that their manufacturing cost as a portion of the overall value chain into finished consumer goods might be tiny. But, without them, there is no further move up the chain at all.

That means if inflation drives up the cost of producing sulfuric acid, plastics or other basic materials, those costs will flow up the value chain. Once there, other firms will need to absorb them. That means squeezing margins, or “squeezing” consumers.

The “foundational” industries

There is a term for those industries that sit along the bottom of the many value-added chains which make up the capital stock of the global economy: foundational industries.

The group includes agriculture, fishing, forestry, mining/excavating and the energy to power the processes they each require. Without these foundational industries, there’s nothing to process at all – no value to add.

There may seem to be little exciting about these industries. Indeed, given the trend in recent years towards “green” investing, basic industries have become an investment pariah.

Investors with strict ESG – environmental, social and governance – guidelines might not be allowed to invest much in these industries, if at all.

But as these industries sit lowest on the value chain, they tend to have strong pricing power. That means somewhat stable margins. This often makes them suitable as inflation hedges for the defensive investor.

While not viewed as a foundational industry per se, infrastructure, including basic transportation, sits alongside them. There is little point to any of the foundational economic activities if you can’t move things from place to place.

Imagine even a relatively simple economy trying to get by without decent roads or grain storage facilities. Or the ability to channel and move fresh water.

One key reason why the Babylonian, Egyptian and Roman empires were so vast and long-lived is they understood the importance of good infrastructure.

When in doubt, go for dividends

Companies that regularly return capital to shareholders with dividends are often the most defensive of all.

They might still be growing. They might still take risks. But they recognise their cash-generation capabilities exceed their capacity to re-invest that cash in their own business.

Hence, they pay out some of that cash to investors as dividends. In short, a high-dividend portfolio is a defensive portfolio.

The good news is there are dozens of UK-listed, multinational companies paying dividends in the order of 10%. Yes, that’s right, you can earn 10% on a diversified portfolio of relatively safe, UK-listed, highly-cash-generative companies.

So, if you’re worried about inflation, widening credit spreads or a possible stock market correction or even a crash, there is a simple, practical, close-to-home solution that will allow you to sleep at night.

But what about the other side of the equation? Sectors to avoid. Tomorrow, I’ll highlight those sectors that are best avoided when things get dicey.

Until next time,

John Butler
Investment Director, Fortune & Freedom