While the Federal Reserve continues to keep interest rates low in order to avoid deflation and spur economic activity, inflation is already here. You don't need the Fed to raise rates to officially signal that inflation is here. If you make visits to the gas station or grocery store, you have felt the rise in prices. If inflation is simply defined as "too much money", then the effect is often a rise in prices.
TUTORIAL: Stock Basics
Inflation and Stocks
While moderate regular inflation is a part of economic growth, inflation is generally not good for stocks. Rising prices means a company has to pay more for its materials or other supplies. Unless a company can pass along those rising costs to consumers, its profits will suffer. As a result, the stock price will suffer. While it may sound simple for a company to pass along its higher costs to consumers, the reality is different. Very few companies have true pricing power. One name that does is Coca-Cola (NYSE:KO) and in a inflationary world, that pricing power ability is invaluable. Proof of that is in Coke's above average return on equity of 42%. Shares also trade at 12-times earnings, and yield 2.9%. (For more, see Staple Stocks Look Good In This Economy.)
Being a low-cost producer or provider of a good or service is also helpful in an inflationary world. Railroads are the cheapest way to transport bulk goods across long distances - they are far more efficient than trucks. Kansas City Southern (NYSE:KSU) is a medium size rail line with pricing power. While shares trade at a rich 29-times earnings today, its future growth prospects look strong.
What to Look For
While it would nice to find companies with perfect pricing power to match inflation, the reality is far different. Even Coke has to slowly and strategically implement price increases. Instead, during an inflationary environment, companies that have an asset-light business model tend to be better equipped to handle inflation. In other words, companies with little receivables and/or inventory are attractive, as are businesses with little in the way of capital expenditures. Two names that come to mind are Visa (NYSE:V) and MasterCard (NYSE:MC), the two largest credit processors in the world. Take Visa, for example, which has a market cap of $55 billion and does over $8 billion in annual revenue. Receivables are negligible at $1.5 billion while annual cap ex is less than $250 million. It's a similar situation for MasterCard. These processors have very little inventory; their biggest asset is the licensing of their respective networks. (For related reading, see How Credit Cards Built A Plastic Empire.)
The Bottom Line
There is no perfect hedge against inflation for stocks. But knowing what inflation-fighting characteristics to look for in companies can yield very valuable results. (For more on this topic check out Inflation Protection For Your Portfolio.)