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SKARBECK: Look beyond gold for inflation hedges

April 23, 2011

Ken Skarbeck InvestingThe threat of rising inflation has investors searching for ways to hedge against a loss in purchasing power. Inflation is generally defined as a sustained rise in the price level of goods and services.

Ideally, investors need investments that provide a “real” return over inflation. Economists talk in terms of real interest rates. In other words, if inflation is running at 4 percent and an investor earns 6 percent, his real return is 2 percent.

“Hard assets” like many commodities—metals and agricultural—are considered inflation hedges. These basic materials, which serve as inputs toward finished goods, can command higher prices in inflationary environments, particularly when demand exceeds supply.

One commodity, gold, is often viewed as the ultimate inflation hedge. Turn on the TV or listen to the radio today and it is impossible to escape the pundits touting gold. Gold has been described sometimes as a currency, sometimes as a commodity, and sometimes as a “store of value.”

Gold investing has always been a bit controversial in the investment community. Consider the remarks of Jim Grant of Grant’s Interest Rate Observer, who is a longtime gold investor: “Gold is not an investment asset. It is a speculation on a certain set of monetary outcomes, mainly on a chaotic set of monetary outcomes.”

Warren Buffett has described the price of gold as a proxy on investor fear, noting, “You really have to hope people become more afraid in a year or two years than they are now. And if they become more afraid, you make money. If they become less afraid, you lose money.”

Investors who are not inclined to invest in gold point out that there is no fundamental way to value gold, and that it pays no dividend and has no earnings. Buffett provides the distinction between investing in gold or an operating business. In his characteristic logic, he notes that if you gathered all the gold in the world, it would form a cube measuring 67 feet on each side worth about $7 trillion at today’s prices.

So, Buffett asks, if you had the choice of owning that block of gold, which you really can’t do anything with except maybe give it a shine, or owning all the farmland in the nation and seven $400 billion companies like Exxon Mobil and still have $1 trillion in walking-around money, which choice would you take?

Finally, gold has been in a 10-year bull market, so today’s investors aren’t exactly discovering the metal at cheap prices.

One asset that has a track record as an inflation hedge is timber. You can almost see why—trees grow a little each year, like keeping pace with rising inflation, then they are harvested. The process is constantly repeated with this renewable resource. Plum Creek Timber and Rayonier are two timber real estate investment trusts whose shares are publicly traded.

Likewise, investments in real estate have historically been viewed as an inflation hedge in that rental income and land prices can rise to keep pace with inflation. For yield investors, treasury inflation protected securities, or “TIPs”, are structured to pay a real return over the inflation rate.

And finally, stocks can be decent performers in inflation, particularly in companies who have the ability to raise prices without experiencing a material decrease in demand for their products.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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