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Friday, March 30, 2012
There's one asset class that appears tailor-made to protect wealth against inflation...
Last week, my colleague Dr. David Eifrig showed you why gold isn't the best way to protect your wealth. He prefers "productive assets"... primarily businesses that command brand loyalty and hold pricing power.
Anyone who read this October essay knows I agree. Bought at the right price, these companies will allow you to compound your wealth for decades.
But there's another class of stocks that will thrive in inflationary times. Make no mistake. I know how horrible the inflation I expect will be for most Americans. But all I can do about it is try to position my readers to keep pace with the inflation that's coming. And these stocks are one of the best ways I know to do that...
There's a reason insurance is the largest business in the world, as measured by revenue. And that reason isn't because insurance is a smart buy.
Insurance is usually a terrible thing to purchase. After all, for the insurance industry to make a profit, you have to have wasted your money. And the fact that the insurance industry not only exists but is the largest industry in the world is nearly a guarantee that when you buy insurance, you're wasting your money. Except of course, if your house does get blown away in a tornado...
For the rest of us, insurance is simply a cost of living. It's like rent and your electric bill. You have to have it. So you pay the toll.
Few investors pay much attention to insurance companies because they are hard to understand... and they seem to take on awfully big risks. But I've learned over my career that many of the best investors always focus their portfolios on insurance stocks.
Consider Warren Buffett, the greatest investor who has ever lived.
The basis of his conglomerate, Berkshire Hathaway, is insurance companies. He writes about insurance in almost every one of his annual letters. This year, he once again explained why he's put insurance companies at the center of his financial empire...
I want to make sure you understand this point... Banks borrow from depositors and investors (who buy CDs) and also from other banks. They have to pay for capital. Likewise, virtually every actor in the financial services food chain must pay for the right to use capital.
Everyone, that is, except insurance companies. Using Berkshire again as our example, let's consider the benefit of getting capital for free (or even being paid to hold it) over time.
Again... I want to make sure you understand how extraordinary this business model can be. Buffett's insurance companies have earned more in premiums than they've paid in claims for nine years in a row. The result is, he's been able to invest the premiums (which total $70 billion) and keep all of the gains for Berkshire. Additionally, he's made $17 billion on the premiums alone. That greatly increases his ability to compound his returns over time.
Just since 2000, the size of Berkshire's float – the amount of insurance premiums it holds for investment, has grown from $27 billion to $70 billion. These premiums aren't like bank deposits. They can't be taken back. They aren't like an investment with a hedge fund. They can't be redeemed. They are paid in full. Thus, they are a form of permanent capital.
That is, even though they are held in trust for the payment of future benefits, all of the actual privileges and income of this capital accrues to Berkshire.
Just imagine if you were given $70 billion a year to manage, where you got to keep all of the investment gains. Now imagine if, in addition to the investment income, you were also paid $17 billion over nine years simply for the privilege of holding the capital!
The nature of this business gives Berkshire – and other insurance firms who can earn a profit with their underwriting and their investments – a truly mind-boggling advantage. And that's not the only one.
Their other huge advantage – and it's a doozy – is that they don't have to pay taxes on those underwriting gains for many, many years because, on paper, they haven't technically earned any of the float until all of the possible claims on the capital have expired. So unlike most companies that have to pay taxes on revenue and profits before investing capital, Berkshire and other insurance companies get to invest all of the float, without paying any taxes for years and years and years.
These companies, then, are sensitive to increased economic activity (which leads to more insurance being sold), interest rates (because, thanks to their float, they are extremely leveraged to the capital markets), and inflation.
Let's assume I'm right, and the value of the U.S. dollar is going to collapse over the next five years. If that happens, the dollars these insurance companies are collecting in premiums today will be invested with the full purchasing power the dollar has now. But they will only pay out claims over the next 10 or 20 years... when the value of that dollar will have fallen by 50% or more.
This inflation/time arbitrage almost guarantees big profits for the entire industry.
The biggest gains will go to the companies that earn a profit on their underwriting – that is, they collect more in premiums than they pay out in claims. Inflation will make future claims more expensive. (Prices will rise and damages will rise with them.) But inflation will also push up the value of the investments the insurance companies make – especially those firms that make equity investments.
There's one overriding consideration... and you must be extremely careful about this... Most insurance companies aren't able to consistently earn a profit on their underwriting. And in those cases, the float becomes a liability. Technically, it's money that the firm might one day owe on a policy.
I'm telling my readers to buy insurance stocks because I believe inflation will increase the size of policies sold... increase the return on float... and enable these companies to profit from the time arbitrage of inflation. (The dollars paid today in premiums will be worth substantially more than those same dollars paid back later.)
Also, the nature of the float means that these companies are hugely leveraged to the financial markets – their investment portfolios are typically large relative to the equity of the firms. If I'm right about a big bull market this year, these stocks will soar.
As Steve Sjuggerud pointed out last week, "Stocks can actually soar during inflation... for a lot longer than people think." Find out why Steve thinks it's too soon to bail out of the market – and exactly when it's time to worry about inflation – here.
THE "DIVIDEND MOMENTUM" TRADE HITS BIG PHARMA
Today's chart shows the "dividend momentum" trade is great for Big Pharma.
Over the past few years, we've stressed the importance of dividends and high-quality stocks dozens of times in DailyWealth. We practically went to your house and made you buy them. Our colleague Dan Ferris even coined the term "World Dominating Dividend Growers" to drive the point home. In a world full of fraud, getting paid steady and growing cash dividends is one of the market's best strategies.
This idea was "stress tested" in 2011. The broad market went through huge swings... and was crushed during the summer panic. Some riskier stocks fell 25%-50% in just a few months. But most of our favorite dividend-payers – like Coke, Abbott Labs, and Altria – held up just fine. (Read about this phenomenon here.)
In the past few months, we've highlighted how more and more people are recognizing the power of basic dividend-payers. With interest rates low, the fashionable thing on Wall Street will be for fund managers to say, "I own blue-chip dividend-payers."
This "dividend momentum" has produced big surges in Wal-Mart, Intel, and Microsoft. It's also pulling Big Pharma shares higher. As you can see from the chart below, shares of high-yielding drug giant GlaxoSmithKline (NYSE: GSK) are steadily working higher... and recently struck a new 52-week high. The rush for dividends continues.