Saturday, November 6, 2010

Effects of Inflation on the Credit Bubble Stocks Short Portfolio

There is a common conceit among investors and pundits that inflation is good for stock prices. This manifests itself in arguments about how monetary stimulus will result in "more money chasing the same amount of stocks," the idea being that all equities everywhere will rise in price in direct proportion to the size of any inflation program undertaken by the Federal Reserve.

A share of stock in a company is different than an ounce of gold or a barrel of oil. The value of a share of stock is the net present value of its future cash flows. The only way for inflation to increase the value of a share of stock is to either (a) lower the discount rate by which the future earnings are discounted (i.e. raise the earnings multiple) or (b) increase the future cash flows (earnings).

Can we say, empirically, that inflation has either of those effects?

Inflation definitely does not raise earnings multiples. See this excellent scatter plot showing that, since 1946, inflation rates higher than 5% correspond to a lower range of earnings multiples. This makes sense intuitively, because why would you invest in equities unless they had a higher earnings yield than the rate of return you could earn owning a basket of commodities?

What about the companies in the Credit Bubble Stocks short portfolio? Will it increase their earnings?

Let's look at Winnebago (WGO). One key feature of its business model is high fixed costs (operational leverage). A key profit driver for them would be to increase sales.

Yet the 2010 Winnebago Tour has a base MSRP starting at $274,554 (does not include tax, title, license, delivery charges or optional features). I actually could not determine from Winnebago's website what gas mileage its 400-hp. Cummins® diesel engine gets, but I suspect it is under 10 miles per gallon.

How enthusiastic for expensive gas guzzlers will our beleaguered middle class be when diesel fuel costs close to $5 per gallon, like in mid-2008? In fact, you can see that the share price of WGO was getting crushed during the summer of 2008 while crude oil (USO) was screaming higher.

On the other hand, some companies' earnings can expect to benefit from inflation. For example, the earnings of an oil & gas exploration and production company are highly leveraged to the prices of oil and natural gas.

This is true of any resource extraction company. The gold miners in the Market Vectors Gold Miners ETF (GDX) will have higher earnings to the extent that inflation or investors' attempts to hedge against inflation cause the price of gold to continue rising.

The companies in the GDX trade at much higher cash flow and earnings multiples than independent oil & gas exploration and production companies. So it would seem that oil & gas is the place to search for cheap inflation hedges. That is what I am doing.

It's hard to imagine a scenario where a little exploration & production company that trades at two times EBITDA wouldn't outperform the chronically unprofitable companies in the Credit Bubble Stocks short portfolio.


Taylor Conant said...


If individual wage rates remain fairly sticky and unemployment levels remain high, individuals may be forced to liquidate stock holdings in order to finance consumption at increased prices thanks to monetary expansion efforts.

Similarly, margin compression and reduced sales volumes could also factor into lower stock prices.

CP said...

Yes, the Winnebago story is about reduced sales volume causing lower margins and earnings.

Taylor Conant said...

Oops! Duh, no wonder that made so much sense.

CP said...

By the way, I really cannot find any information about what gas mileage the Winnebago Tour gets!

Taylor Conant said...

Call a Winnebago dealer

JamesDavid said...

I was able to find this regarding the gas mileage of a WGO:

"We've been in an '06 Adventurer 37B, towing a Chevy Tracker, for almost three years and since July of last year have been in it full time. It wanders a bit, we feel most of the expansion joints and pot holes, and we probably could use a bit more power when going up those steep grades. Gas mileage is at about 6.5 to 7. But... given all those negatives, for want of a better term, we love the coach and are very comfortable in it. Would a diesel be nicer, maybe, but they are a lot more expensive to buy and to run. I would be hard pressed to switch to a different rig but when and if we do switch it would, more than likely be to another Winnebago."

See (emphasis added).

CP said...

Perfect... so that is a different model (smaller?) and the gas mileage is terrible as we suspected.

PD said...
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CP said...

Post that again... I'm not sure what happened?

PD said...

Diesel is way more of a heavy truck fuel than gasoline. You want to haul a heavy load you use a diesel engine. Trains, trucks doesn't matter. For turbines, you use rocket fuel - basically it has to do with the energy the fuel contains. Gas then diesel then rocket fuel.

So to manage the value between the three you have to look at a frac spread or pricing arbitrage between the three. Any refinery 10k or q should talk about this. Look at Suncor because they just commissioned a big diesel upgrade in Alberta.

In terms of trucks the below is from truck trends....
Advantage: Split Decision
Typically, gas engines make more horsepower, while diesels produce more torque. Are you looking for off-the-line acceleration of an unloaded truck? Maybe you use your truck around town where quick starts are important and you don't often tow a trailer or haul a load. If this is the case, then you'll want a gas engine. By design, gas engines rev faster and are able to reach higher rpm peaks than diesels. This allows them to attain greater horsepower numbers and quicker 0-60-mph times.

However, if towing capacity and brute pulling force are your game, a diesel is for you. The torque advantage of diesels is perfectly suited for pulling heavy loads up steep grades. Because of the relatively high-compression ratio necessary to ignite the diesel fuel (17:1 diesel versus 9:1 gas), a diesel makes all its torque and power low in the rev range. As an example, the GM 8.1L gasoline V-8 in Chevrolet and GMC pickups puts out 340 hp and 455 lb-ft of torque, while GM's 6.6L V-8 turbodiesel makes slightly less hp at only 300, but makes up for it in torque with a healthy 520 lb-ft of grunt.

Fuel Economy
Advantage: Diesel
Diesel fuel has a higher energy density than gasoline. One gallon of diesel contains approximately 147,000 BTUs of energy, while a gallon of gasoline only has 125,000 BTUs. This means it takes more gasoline to equal the power output of diesel, making diesel engines more efficient per gallon of fuel burned. Also, because diesel engines use the more efficient direct fuel-injection method (fuel injected directly into cylinder) compared to the port fuel-injection setup in gas engines where gas is mixed with incoming air in the intake manifold, the diesel system has little wasted or unburned fuel. Diesels also use about one third as much fuel at idle as gasoline units. Even though there are no official EPA-mileage figures for 3⁄4-ton and bigger trucks, we've seen diesels get six to eight more mpg than similar-weight gas pickups. Over the life of the truck, this advantage could be significant, especially if you drive a lot of miles."

So based on this, the above from James is not a good comp. I like Taylors suggestion of phoning a dealer.

I looked up some blogs and people are suggesting 17-20mpg - this makes more sense than 6-7.


CP said...

I think double digit mpg numbers would only be for the smaller models.

The massive land yachts get single digit mpgs even on diesel, I'm pretty sure.