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The Best Way to Hedge Against Inflation

By Bill Spetrino   |   Friday, 18 Feb 2011 10:07 AM

Smart investors and market commentators, such as John Paulson, Warren Buffett and Marc Faber, have recently argued that purchasing appropriately priced stocks is one of the best ways for investors to prevent their wealth from diminishing from the effects of inflation.

The argument is that certain businesses — with low material costs and high markups combined with pricing power and a strong competitive moat — are able to pass along input-cost increases to customers. Therefore, earnings are able to increase faster than the rate of inflation.

A couple of guys argued against that recently. They claim businesses traded in 1981 for less, relative to book value, than they did in 1973. As a result, stock prices increased slower than book values.

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The S&P 500 added only 3 percent annually during this stretch — again including the after-tax value of dividends — but since inflation compounded at 9 percent per year, stocks’ real value declined 40 percent.

How did gold do? Followers of the gold markets know that gold spiked from about $100 an ounce in August 1976 to more than $825 an ounce in January 1980. That is equivalent to about $2,200 in today’s dollars. The current price is about 60 percent of the inflation-adjusted highs 31 years ago. Inflation was more than 10 percent every year from 1979-1981

So gold is a better hedge than stocks right? Not so fast.

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The 25 highest return on equity, or ROE, companies in the Fortune 500 compounded book value at 15 percent annually from 1973 to 1981.

That was much faster than the 9 percent inflation compounded annually. Berkshire Hathaway — the holding company of my investing mentor Warren Buffett — compounded his book value at around 20 percent.

My top two selections in my Dividend Machine have ROEs of more than 80 percent and have outperformed gold during the past 11 years. Gold has compounded at more than 17 percent annually in that time. My top stock boasts 23 percent with reinvested dividends in that time frame.

By combining safety, income and growth at an appropriate price, it is my belief that such stocks I choose for my Dividend Machine can offer investors the best opportunity to compound their wealth, irrespective of the inflation rate.

About the Author: Bill Spetrino
Bill Spetrino is a member of the Moneynews Financial Brain Trust. Click Here to read more of his articles. He is also the editor of the Dividend Machine. Discover more by Clicking Here Now.

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