Inflation-proof your portfolio

By Harry Domash

Stocks have been buffeted in recent days by concerns about rising inflation. Are those concerns well-founded? As usual, some economists say yes, others no.

Nevertheless, successful investing is about reducing risk.

So it pays to consider inflation-proofing your portfolio, just in case the doomsayers are right. I'll give you some ideas in a minute, but first some background.

Why worry now?

Inflation hawks point to two reasons for concern:

• Sharply rising energy costs.

• The $100 billion or more the U.S. government will spend on hurricane-relief projects.

It's easy to see why energy costs are a concern. Energy figures into the cost of almost everything. But the relationship between government spending and inflation may not be so obvious. Basically, it's all about the classic supply-vs.-demand equation.

Because money the government spends flows into the general economy, the new hurricane-relief cash translates into increased demand for goods and services. If the increased spending makes demand exceed supply, prices go up and we have accelerating inflation.

Manufacturers, to meet increased demand, borrow to expand production, increasing the demand for money, which drives interest rates higher. The Fed tries to slow the whole process by hiking interest rates, which is expected to curb spending.

Who wins and who loses in an inflationary environment?

Inflation's winners . . .

Gold prices have historically moved up with inflation. Prices of many other commodities, such as oil, grains and metals, also rise when inflation accelerates.

Also, certain industries tend to be inflation-resistant. Whatever happens, consumers still buy food and household products. They still get sick, go to doctors and hospitals, and purchase health-care products. Offices may put off buying new computers, but they must still purchase office supplies when they run out.

Consequently, the health-care industry, as well as food, household-product makers and manufacturers of other rapidly used-up necessities, don't suffer much in inflationary times.

. . . and losers

High interest rates usually kill sales of big-ticket items that most buyers finance, such as housing or automobiles. Related industries such as mortgage finance, furniture and auto parts also suffer.

In a minute, I'll describe a screen for finding stocks worth considering in a high-inflation environment. But first, two ideas that don't lend themselves to screening.

Buy gold

Because gold prices tend to zig when the rest of the market zags, some experts advise diversifying your portfolio with gold even if you don't see inflation on the horizon.

But how do you invest in gold?

Until very recently, gold-mining stocks were the best way to profit from rising gold prices. But that approach was far from perfect because mining companies' share prices frequently don't move in tandem with the price of gold. Variables such as a mine's depletion rate, production costs and hedging strategies complicate the picture.

But here's the good news: Recently, a better way to profit from gold-price swings became available in the form of new exchange-traded funds. The first, streetTRACKS Gold Shares (GLD, news, msgs) started trading in November 2004. Then, just two months later, in January, the iShares Comex Gold (IAU, news, msgs) became available.

Both attempt to track the day-to-day price movements of gold bullion. You can research them in detail in MSN Money's new ETF center. Both funds have produced almost identical results since Feb. 1, 2005.

Buy commodities

Commodities are agricultural or mining products such as wheat, cattle, oil, gold and metals. Similar to gold, commodity prices usually rise during inflationary times.

Until recently, the only way to profit from rising commodity prices was by buying futures options, which is risky business.

Now, however, the Pimco Commodity RealReturn (PCRDX) mutual fund gives you a way to profit from rising commodity prices without running the risk of having a carload of pork bellies delivered to your front door. The fund emulates the Dow Jones AIG Commodity index, which tracks futures contracts on 19 commodities. Its biggest positions are in crude oil (13%) and natural gas (12%). It has a 6% weighting in gold.

Buy health-care stocks

Health-care companies, unlike companies in other inflation-resistant sectors such as food and consumer nondurables, are still growing at a good clip. That's a big plus, because by sticking with a growth industry, you might still make money, even if inflation doesn't happen.

I used MSN's Deluxe Screener to list stocks in health-care subsectors of interest and set up a few simple screening parameters to isolate the best prospects.

Pick your category

The Industry Name parameter (under Company Basics) specifies a category within an industry, such as the Diagnostic Substances category within the Drugs industry. If you think I overlooked a promising category, open any of my screens and choose a different industry name.

• Screening Parameter: Industry Name = (put your choice here).

Profits are a must

For my inflation-resistant portfolio, I want rock-solid companies, so profitability is a must.

Return on Equity (ROE), which compares net income to shareholders' equity (book value), is the most widely used profitability measure. Many professional money managers won't consider stocks with ROEs below 15, so that's what I used.

• Screening Parameter: Return on Equity >= 15

Sales count

Because I'm looking for established companies, significant sales are a must. While $100 million sounds like a big number, more than 3,000 U.S. companies rack up annual sales higher than that figure.

• Screening Parameter: 12-Month Revenue >= 100,000,000

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