This article is excerpted from Tom Yeung’s Profit & Protection newsletter dated July 21, 2022. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
Finding stocks that will survive high inflation is more complex than it seems. Prices of energy and basic materials — traditional inflation hedges — have fallen over concerns about sagging consumer demand. Retail investors rushing into companies like Indonesia Energy Corp (INDO) and Houston American Energy Corporation (HUSA) have seen their positions nearly wiped out.
Meanwhile high-growth tech companies have fared no better. Firms from Expedia Group (EXPE) to Coinbase (COIN) are seeing share prices collapse as customers tighten belts and close their wallets this year.
When inflation is paired with an economic slowdown, the resulting “stagflation” tends to hammer every industry.
Yet, certain classes of stock tend to survive… and even thrive… from rising prices.
Some of these firms benefit from higher demand. Discount retailers like Costco (COST) and Dollar General (DG) are natural substitutes for customers trying to stretch every dollar. Social media and traditional news outlets alike are now salivating over Costco’s $4.99 rotisserie chicken.
Other firms use financial or operational leverage to turn rising prices into a windfall. If an egg farmer’s breakeven cost is 90 cents per dozen eggs, a 50% increase in wholesale prices from $1.00 to $1.50 translates into a 6x gain for the farmer (Profit rises from $0.10 to $0.60). It should surprise no one that egg producer Cal-Maine Foods (CALM) is up 40% for the year.
These companies tend to perform best in early-stage recessions. As inflation continues, however, the demand for rotisserie chickens and eggs will likewise slow. Prices of 2008 recession winner McDonald’s (MCD) saw losses in the second half of the financial crisis.
Investors looking for more all-weather inflation winners need to look further afield to the second-order winners. And one class of stocks stands to gain, regardless of the economy:
Community and regional banks.
Bank Stocks: The Second-Order Winners
The banking industry has long benefited from rising interest rates. Banks can take customer deposits (currently averaging 0.03% interest per year) and deposit them with the central bank for higher rates. On Friday, the prevailing Interest on Reserve Balances (IORB) rate climbed to 1.65%, its highest level since the start of the pandemic.
The wedge between these figures is known as the Net Interest Margin (NIM). It’s how most banks make money and why community banks such as CVB Financial (CVBF) have seen shares rise this year. When the Fed raises interest rates to fight inflation, these firms naturally benefit from larger NIMs.
Banks that invest in higher-returning assets such as treasury bonds and bills also benefit. My top banking pick Charles Schwab (SCHW) earns more than half of its revenues from interest on federally-backed mortgages; analysts expect Schwab’s net interest income to rise 30% this year.
A Word of Warning
Not all banks, however, are stagflation winners.
Companies like Capital One (COF) earn interest from credit cards, while those like Ally Financial (ALLY) do so from car loans. An economic slowdown can quickly cause loan losses at such firms to spiral out of control, as mortgage-backed lenders found out in 2008. Poor underwriting standards will do the same.
Investment banks are also at risk in a broader economic slowdown. This week, Goldman Sachs (GS) joined other bulge-bracket banks reporting bad news: Investment-banking revenues plunged by 41%, though that’s light compared to a 55% decline at Morgan Stanley (MS) and the 61% drop at JPMorgan (JPM).
In other words, investors seeking protection from inflation need to find:
- Steady NIMs. Conservatively run banks with a history of minimal loan losses in crisis periods.
- Moderate Revenue Growth. Average-growing financial firms outperform their faster-growing peers (The Profit & Protection system finds overly-fast growth is a red flag)
- Positive Profit & Protection Scores. Rising momentum and strong returns on capital at a reasonable valuation.
5 Stocks to Buy as Inflation Surges
Fortunately, smaller banks tend to fit the bill. These firms lack the trading, investment banking and personal-loan businesses that define more cyclical banks.
And though they all run the risk of hiding bad loans (since modern GAAP accounting principles are weak at sniffing out issues), an investor buying a basket of these conservative stocks stands to benefit even as inflation rages on.
- FinWise Bancorp (FINW). A Utah-based fintech bank focused on SBA-backed loans. The company earns 15% net interest margins, which translates to >30% return on equity (ROE). A 1.5x price-to-book ratio gives some breathing room should its lucrative (though sometimes questionable) partnership business unravel.
- Bank7 Corp (BSVN). An Oklahoma-based community bank with an eye for cost control. This company’s efficiency ratio of 36% is far better than the 50% benchmark that most banks use, leading to a 2x to 3x higher ROE.
- First Citizens BancShares (FCNCA). A recent merger with CIT Bank in January created this 100 billion behemoth with significant cost-saving potential. Analysts expect the bank’s efficiency ratio to improve 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 collateralized commercial real estate lending offers the firm strong downside protection.
- Citizens Financial Group (CFG). A regional Northeast bank with 900 branches. The company is slower-growing than most community banks due to its high costs, but makes the Profit & Protection list thanks to its exposure to rising net interest margins.
- PNC Financial Services (PNC). A well-run bank that has completely changed since the 2008 financial crisis. The firm has since acquired National City and RBC’s U.S. branch network to become America’s second-largest regional bank. Analysts are forecasting double-digit growth in net interest income for the next several years.
Community Banks: The Hidden “Protection” Investments
It’s easy to overlook community banks. These slow-growing firms rarely make headlines (unless you count American Banker Magazine).
Yet, these firms not only outrun inflation, but thrive in rising-rate environments. When rates rose between February 2016 to 2018, the SPDR S&P Bank ETF (KBE) rose 80%, beating the broader S&P 500 (40%) and even tech (60%).
The best financial firms are also Perpetual Money Machines. Insurers like Warren Buffett’s Berkshire Hathaway (BRK) and banks such as U.S Bancorp (USB) convert 20% ROEs into book value growth. A decade of 20% growth rate multiplies a company’s value six-fold, thanks to the magic of compound interest.
That’s why these companies continue to hold a place on the Profit & Protection watchlist. When you’re looking to protect gains from inflation, it pays to keep some high-quality banks in your back pocket.