5 Stocks at Risk for Inflation

Stocks have suddenly gotten pricey again. The S&P 500 index has rocketed past 940 after dipping below 685 not quite three months ago. That puts it at 22 times trailing earnings and 17 times forecast 2009 earnings. The average of more than 130 years is less then 15 times trailing earnings (using a stricter definition of earnings than I’m using above). The dividend yield has shrunk to around 2.3%, half stocks’ historic average. That would be more alarming if it could be blamed entirely on rising prices. It’s partly explained by dividend payments having fallen to what will likely be the lowest percentage of earnings since 1938.

So sell something. Focus on shares that seem particularly expensive (Yahoo (YHOO) at more than 30 times earnings), ones that don’t pay decent dividends (sorry, Apple (AAPL)) and cases where it’s not yet clear whether you’ve been wise or lucky (Citigroup (C) has tripled since March). If you don’t own such stuff, consider which companies might get hurt the most by inflation.

Inflation is both nowhere to be seen and on most investors’ minds at the moment. Consumer prices were flat in April versus a year ago after falling in March, but massive government spending and gaping budget deficits have raised fears that once the downward pull of recession eases, inflation will roar. If it does, stocks as a class should do well long-term, though they might wobble a bit in the near term. In “Stocks for the Long Run” Jeremy Siegel reported returns versus inflation over 135 years ended 2006. After periods of “high” inflation, stocks did well over both one-year and 30-year holding periods. Following “very high” inflation, stocks did well over 30-year periods but poorly during one-year periods (not as poorly as bonds, though). So stocks are a good choice for all but the nimblest of traders. In recent columns I’ve focused on which types of stocks outperform during inflation (and why gold is overrated for the job). Consider now which types of stocks might do poorly during inflation.

Start with home builders. Most are nowhere close to profitable at the moment, but their shares have rebounded nicely. Lennar (LEN), Ryland (RYL), Toll Brothers (TOL) and DR Horton (DHI) are up 15% to 45% in three months. Houses still appeared too expensive when I looked at the numbers in February, and a glut of inventory doesn’t bode well for builders (even after Tuesday’s rosy pending home sales figure). Inflation might stabilize prices, but it also tends to drive interest rates, including those for mortgages, higher. (In recent weeks, 30-year mortgage rates have risen about three-quarters of a percentage point.) That could delay by years a recovery in new construction demand. Builder shares seem reasonably priced and the companies are either financially strong (Toll) or raising enough capital to survive (Lennar), but if you expect inflation, it’s a good time to unload them.

I appreciate the long-term prospects of The Pantry (PTRY), which operates like a roll-up of mom-and-pop convenience stores, and shares look cheap at just eight times this year’s earnings forecast. That said, last summer provided a harsh lesson in just how sensitive the company is to a spike in oil prices. Customers grumble about gas stations profiting when prices rise, but most make little money from gas, counting instead on higher-margin snacks and such. A rise in prices at the pump leaves less money for customers to spend in the stores, which shrinks operating profit fast. Last summer the stock briefly dipped below $10. It’s over $21 now. I’d feel better about the price if crude wasn’t shooting higher again and if Pantry didn’t have debt equal to double its stock market value.

Dollar Tree (DLTR) has had a great run. Shares have doubled since January 2008. The company’s stores mostly sell goods at the fixed price of $1, and strapped shoppers have lately been keen on discounts. There are two problems, though. First, the company isn’t called Dollar-Indexed-to-Inflation Tree. Rising wholesale prices work against companies that resell at fixed prices. Second, the stock has risen to 16 times forward earnings. Buy the $1 candy corn come Halloween, but leave the shares alone for now.

Finally, companies that sell needed goods like food and household products should do fine during inflation. Their materials prices will rise and their margins will temporarily contract, but they’ll quickly pass higher prices along to customers. That only goes for the ones that have room to spare in their margins, though. Low-margin companies might slip into unprofitability. Worse, since they specialize in the lowest-price brands on supermarket shelves, and in the frugal customers that favor them, these companies will have less of an ability to pass price increases along. For food makers, Kraft (KFT) looks problematic, with its exposure to low-margin dairy. Swap it for the likes of Heinz (HNZ) or Unilever (UN). For household products, much as I like the fast-improving Church & Dwight (CHD), buyers of its Arm & Hammer detergent probably aren’t as loyal as those who pay a premium for Tide. Switch to Proctor & Gamble (PG) if you fear inflation, and get a much bigger dividend yield in the bargain.