Baker Street, London -- In times gone by it was accepted wisdom that equities were a good place to put your investments during times of high inflation. The theory was that companies would be able to raise prices at, or even above, the rate of inflation and hence maintain the real value of the company. Higher revenues meant higher profits and that meant higher dividends.
This was in marked contrast to buying gilts (government bonds) or putting the money in a savings account. It wasn't much fun getting interest at 10% if everything in the shops was going up at 12%. The only way bonds could offer a good return was if their price fell far enough to give a good yield. That was why in the mid-1970's, gilts sold by the government at £100 nominal value traded as low as £17.
In the days when inflation was a problem, the world and the UK, were very different places. Britain was virtually a command economy. To buy foreign exchange you had to get permission from the Bank of England. You were not allowed to hold accounts in foreign currencies. The government itself determined the price of money (interest rates) and to get a mortgage you had to show a consistent record of making deposits and saving at your local building society. There was no point in asking the banks; they didn't "do" mortgages.
Basically everything was in short supply and choice was limited. This enabled people to raise prices for goods and service with no fear of being undercut.
Today's world is one of free flowing capital and intense price competition. You want a book? Buy it on-line through Amazon.co.uk. You want a mortgage? There are 4,500 available, from one of fifty different providers. Even if, God forbid, the government took back control of interest rates from the Bank of England, it is hard to see a return to those days of shortages and controls.
Although official figures show that we still suffer from inflation -- the value of money is falling -- it is clear that in some areas the value of money is rising. In other words, you will be able to buy a better, or a bigger product, if you wait a little while. When this happens it is called deflation. It is not happening yet in the UK across the board, but it certainly cannot be dismissed as a possibility.
Today, it is hard to think of any product or service that is not in oversupply. This has led to ferocious price-cutting. When combined with rapid advances in technology, it is clear that the prices of many goods, and indeed services, are actually falling. Everyone is aware that prices of PCs are falling, but it also applies to many other items too -- like cars, airline tickets and many household products.
Certainly if the Bank of England carries on with current policies on interest rates then it seems likely deflation will happen. And deflation is not uncommon. It has been the norm in Japan for this decade and it lasted for 10 years in the USA after the great crash in 1929. In December 1989 the Japanese Nikkei Index peaked at 38,900. Today, 10 years later it is 17,400.
Deflation may yet happen. If it does, how should we react to it? And if equities are good in times of inflation does it mean they are bad during periods of deflation?
Like all things it depends. Some equities are better than others.
What is clear is that simply relying on inflation to push up the prices of your products is not going to work. The distress in the retail sector from Marks & Spencer (LSE: MKS) down is testament to the pain already being inflicted by low inflation. What would it be like if outright deflation really took hold?
Retailers are probably the most obvious sector where falling prices are a problem, but the threat of lower prices, or the inability to push prices up has also been reported in the services sector by Rentokil Initial(LSE: RTO).
If a company is unable to grow by raising prices then the only other alternative is to increase volumes, a policy famously and successfully pursued by Tesco (LSE: TSCO) at the expense of its great rival J. Sainsbury(LSE: SBRY). The problem here is that unless you increase market share you can only increase sales at the rate of total market growth. In a mature economy, like the UK, that is not going to be much more than 4% in nominal terms.
An additional feature that will hurt retailers is the development of the Internet. Who needs a shopping mall when you can shop on-line?
Increasing market share is a normal business expansion model, but it is usually associated with some margin erosion and, of course, there is a limit to how far one company can grow. Normally, the competition authorities would take a keen interest if one sector shrank to only a few major participants. The banks and supermarkets are good examples of sectors where consolidation by mergers of existing players is unlikely to be allowed -- although the fighting over NatWest(LSE: NWB) seems remarkably unspoilt so far by consideration of the views of The Competition Commission.
So if signs of incipient deflation already exist what other sectors might suffer?
If we take Japan as a guide, then property is certainly one sector to avoid. That makes sense if we think about it. If the value of money is rising then it means the price of fixed assets like land and commodities must fall. These so-called hard assets were very popular in the seventies and eighties as a way of preserving wealth during inflationary times. If deflation comes then it stands to reason they should be avoided.
Resources, such as oil and metals, ought to be obvious casualties of deflation too. In that case there isn't much point in holding the oil or mining companies.
Industries with gross over-capacity, like cars, will also have very tough time so they are best avoided as well.
But it is not all bad news. Deflation is very good for the bond market. Yields on Japanese government bonds fell as low as 1% last year. Even now, with clear signs of recovery in the Japanese economy, these bonds still only yield 1.9%. Someone who held bonds through the Japanese recession would have done very well indeed.
The biggest holders of bonds are insurance companies: both life and general. This ought to suggest that they should do very well from their investment portfolio. For general insurers this is probably true, but that may not be the case for life assurance companies. The problem for the life companies is that much of their portfolio is in the equity market and that won't do particularly well in a deflating world. Even now many life companies are cutting back on annual and terminal bonuses as rates of returns have fallen below the levels provided by the seemingly remunerative inflationary years.
General insurance companies might be luckier. If they are insuring assets like motor cars and white goods it could well turn out that the replacement cost will be lower than the insured value. If they could get away with replacing like for like, then they ought to be able to make a profit on the underwriting side of the business. And that is a rare event for an insurance company. It is hard to look at companies like Royal and Sun Alliance (LSE: RSA) with its dividend yield of 5.3% and a price to book ratio of 0.97 without wondering if there is some value there.
A deflationary world is one of falling prices, so the only way a business can grow is by increasing volume. Mature businesses will only grow at the rate of economic expansion of the country, plus a little bit perhaps for increases in market share. So for successful investment we need to find industries with above average growth potential where there is still a premium for delivering a good or a service.
So which industries are growing fastest?
The Internet obviously and, on the back of that, telecommunications. In fact the whole new media sector, radio, TV and Internet is booming. Advertising on these media is also thriving. However, these changes in the media are also creating new technologies such as interactive gaming, flat panel loud speakers and 3D graphics. Mobile phone usage is growing at a good clip, so operators and everyone involved from handset makers to chip designers should benefit.
Health care and drugs must be a no-brainer too. Everyone wants to stay healthy and live longer. This is a market that can surely never be fully satisfied. Moreover, there seems to be no end to the ingenuity of drug designers and only a modest reluctance on the part of governments and insurance companies to pay for new drugs. The sector seems to be on a winner.
The next biggest sector is oil. While there is little doubt that we all need petrol and all the chemicals created from oil, will it really grow faster than population growth? My guess is that it won't, but that maybe wrong if the emerging markets like China and India really start to get motorised.
People's leisure activities are becoming more complicated. No longer is a wet Saturday afternoon spent watching Rangers United thrash City Rovers sufficient. Today's wage slave needs to hop a jet to Iceland, or interact with a high tech games machine. Whatever he or she does is going to involve a lot more money than the previous generation spent on leisure. So that sector should be a lucrative area for investment. In that bracket I would include travel and restaurants as well.
The problem though is that everyone seems to know which are the high growth stocks already, and has bid them up accordingly. Psion (LSE: PON), part owner of the Symbian consortium developing the EPOC operating system for mobile phones, is on a prospective price earnings ratio of 419. Is there really growth there that has not been priced in yet? At the other end of the spectrum faded stars like retailers seem to find no support despite offering yields that in some cases are in excess of long-term gilts.
And here is the crux of the problem. What is the trade off between growth and value? Sure, retailers might offer little, or even no growth. But if they are offering cash yields of 6.6%, as the retailing sector is in parts, that is pretty attractive if prices are flat or falling. Returns of that level are enticing if they can be maintained. But here is the rub. There is no guarantee that these payouts will continue. Given the stress in some of these businesses some large dividend cuts must be on the cards. If that happened the carnage on the market could be quite awesome.
Nevertheless, few people would contemplate companies like Marks & Spencer passing the dividend. More likely is a significant cut. So real value players should try and estimate the size of the cut and then see if the shares stack up as yield play.
But even then there is not much joy in getting a 6% dividend yield if the capital value of your shares is falling at 6% a year. Remember that M& S shares are now at the same level as they were in 1991, 8 years ago, and they have been as high as 633p.
So yield alone won't be good enough to support a share if the business is shrinking. In fact if the business is shrinking you just don't want to be in it at all. There is just too much risk that it will just financially implode and take you down with it.
However, there is an argument for investing in stable industries that generate good cash flow and can pay healthy dividends. The difficult part is differentiating them from businesses in decline.
If deflation is to become a part of our culture, one thing is clear. A lot of the investment rules and guidelines of the last 30 years might have to be thrown out of the window. The question is: What will the new rules be? Tell us what you think on the Investment Strategies message board.
