The best way to beat inflation and deflation

February 9, 2010
Bangkok, Thailand

Money is just a tool… nothing more. It’s not the only tool, but it’s certainly a useful one that can be leveraged to acquire more freedom; we can trade money for time, money for health, money for experience, and money for assets that safeguard ourselves and our families.

As such, it certainly behooves any free individual to have some means to generate capital– this can often be through a business or entrepreneurial venture.

Once wealth has been accumulated, though, it is equally important to be able to maintain and grow the account through sensible, well-grounded investments.

Before allocating any investment capital for the long-term, though, investors need to address a fundamental question: will the world’s pent-up economic deficiencies ultimately result in inflation or deflation?

This is an absolutely critical issue to resolve because the investment implications of either case are drastically different. In a deflationary scenario, prices fall. This means that that cash and reliable cash equivalents gain in value while stocks and commodities are losers.

In an inflationary scenario, the general price level rises. This erodes the value of cash against goods and services while the value of stocks and commodities rise.

A completely objective analysis shows very compelling evidence for both sides.  Record high deficits, soaring national debts, and unprecedented expansion of central banks’ balance sheets, particularly in the western world, absolutely portend future price inflation.

Each of these influences effectively creates more paper currency without a similar increase in the aggregate amount of products and services available in the economy.

In addition, consider the effects of population growth, demographic shifts in the developing world, resource scarcity (water, arable land, oil), climate change regulation, and of course, rising taxes in bankrupt western economies.

The combination of these elements certainly seems to make an obvious case for substantial price inflation.  The evidence for deflation, however, is equally compelling.

The accumulated and potential destruction of wealth from toxic assets far surpasses the amount of money that governments are printing, while anemic unemployment and GDP growth rates are pushing down aggregate demand and price levels.  The emergence of new technology also has an effect on reducing price levels.

Moreover, much of the new liquidity created by central banks is not making its way into the financial system.  Risk-averse commercial banks have become a bottleneck to new money creation, and a further meltdown in commercial real estate, sovereign debt, etc. will reduce banks’ willingness to lend.

This credit contraction will reduce the amount of money circulating in the economy, putting downward pressure on price levels.

For someone to invest blindly and unhedged for the long-term without objective consideration for both sides of the argument is frankly irresponsible.

With due regard for both inflationary and deflationary contentions, I think one of the most sensible investments to make right now are high quality companies that trade at a discount to their tangible book value.

In other words, I’m talking about strong companies in growth industries that are woefully undervalued by the market relative to their net assets… small town newspaper chain sitting on a mountain of debt– bad; profitable energy company with enormous cash reserves– good.

This way, if the world undergoes a deflationary cycle, your investment will have essentially bought you cash at a discount, likely one of the best investments you could make.

Otherwise, if the inflation gorilla wins out and prices soar, the company’s earnings and stock price should keep pace, maintaining the value of your capital.

These types of companies are absolute gems, and not to mention quite difficult to find. And you can forget about scoring one in most emerging markets; stocks in China, for example, trade at dizzying multiples of their earnings and book value– think in 1998.

Conversely, the Tokyo Stock Exchange has several undervalued companies right now; Japanese stocks are trading at much lower valuations than most other markets because local investors there have fled low-yielding, yen-denominated assets.

Instead, Japanese capital has been parked in places like China, Thailand, and Australia, where even a simply term deposit account can yield 8%. The exodus of capital has left the Japanese stock market with miniscule valuations, and many companies are trading at less than their book value and at a single digit multiple to their earnings.

Overall, I’m negative on Japan… but even a long-term stagnant economy has solid companies that will continue to be profitable year after year.

If you want to find out more, I’d encourage you to take a look at The Casey Report, which is without doubt one of the best macro-level investment advisories out there.

The most recent issue has some really brilliant commentary on the Japanese market, and the research team routinely uncovers some of these deeply-discounted companies that I’m talking about.

In fact, I’m about to put a BUY order in for their most recent recommendation, a marine transportation company that specializes in the upstream oil and gas industry. It’s trading at a mouth-watering discount to its tangible assets, and is loaded with cash… a very safe bet, in my opinion.

You can read more about it here.

About the author

James (aka Simon Black) is an international investor, entrepreneur, and founder of Sovereign Man. His free daily e-letter Notes from the Field is about using the experiences from his life and travels to help you achieve more freedom, make more money, keep more of it, and protect it all from bankrupt governments.

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