Raging debate.

The investing world has divided itself into two camps: those fearing inflation and those fearing deflation. A debate is raging about what we’ll face going forward and the appropriate way to invest under each scenario.

This debate is not between dummies. I’m not referring to the talking heads on TV or the perma-bulls of Wall Street who perpetually advise buying stocks NOW! Nor am a talking about the perma-bears and gold bugs that advise canned food and fall-out shelters.

I’m talking about the smart investors who saw the 2000 tech bubble and the 2008 housing bubble popping years in advance. They made money when almost everyone else lost it.

They were in complete agreement back in 2000 and 2008, but now they aren’t. Now, they hold diametrically opposed views about the economy and where to invest.

If we face deflation, you should hold cash and buy high quality fixed income instruments. If we face inflation, you should buy commodities and stocks that will thrive in a rising price environment.

They are in total disagreement about which one we face and are ripping each other to shreds in articles and interviews. I’ve never seen such strong disagreement between the smartest in the field.

The outcome really matters. If you invest in cash and bonds and inflation occurs, you’ll get killed; if you invest in commodities and stocks and deflation occurs, you’ll get killed. This is no mere academic debate. This will impact the lives of millions of investors.

Like many, I don’t know how this story ends. It’s my opinion we’ll experience deflation until bad debt is squeezed from the system and then inflation from there. The problem is getting the timing right of when we go from deflation to inflation (and correctly guessing ahead of the herd when the crowd will recognize that shift).

And, to further confuse things, the outcome depends more on the decisions of government officials than economic analysis. If they print lots of money, we’ll get inflation. If they don’t, we’ll have deflation. We’re in an uncomfortable position.

I don’t think it’s possible to get the timing right, so I’m not trying. Instead, I want to own instruments that can do well in either inflation or deflation. For me, that’s investing in businesses with pricing power and competitive advantages that can cut costs in deflation or raise prices in inflation.

I prefer businesses with cash on hand and that pay a meaningful dividend. That’s the same as owning cash and a fixed income instrument, but it has the benefit of adapting to inflationary conditions in ways that cash and bonds can’t.

I’m also favoring strong management teams that own a significant chunk of the business and are focused on building shareholder wealth. A smart management team can adapt and exploit a changing environment in ways that cash, fixed income, canned goods and commodities can’t.

In other words, I’m looking for the best of both worlds. I don’t want to guess whether we’ll experience inflation or deflation or when one or the other will kick in. Instead, I’m investing for either environment.

Such investments are likely to feel short term pain if either strong inflation or deflation occurs. But, in the long run they will survive and grow in ways the other alternatives can’t.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

How to invest with deflation/inflation

Last week, I talked about why I thought we’d be experiencing deflation over the short term and inflation over the long run. This week, I’ll discuss how to invest in both scenarios.

A deflationary environment is the harder of the two.

The thing that does best is U.S. government bills, notes and bonds. This was clear late last year as U.S. Treasuries were the best performing asset class. Cash and gold did okay as well, but U.S. Treasuries were the all-star.

Not much else does well in deflation. Some people think other bonds like corporates or municipals or mortgage backed do well, but I beg to differ. The problem is that deflation usually leads corporations to collect less revenue, thus increasing default and bankruptcy risk. Municipalities suffer from less tax revenue and, unlike the Federal government, can’t print money or run huge budget deficits. Mortgage backed bonds do poorly for the same reason as corporations–people default on their loans under deflation.

Gold tends to hold its value, but it doesn’t produce any cash flow and it is very expensive to store, insure, etc. Cash is a great thing to have, especially if you can deploy that cash as deflation is bottoming and before inflation has taken off.

Stocks tend to get clobbered during deflation. Some companies do better than other, though. High quality companies do better than low quality companies. Companies with pricing power–that can raise and lower their prices easily–tend to do well. Companies with low or no debt do well.

Another problem with investing during deflation is timing. If deflation increases or decreases, it can dramatically impact returns. If you are sitting in U.S. Treasuries when deflation bottoms, you can get clobbered (and many have since January). Nobody can time the market, so trying to go to Treasuries and jump back into stocks or other risky assets is very tough. I don’t know anyone who can consistently do it.

Inflation is an easier environment to invest in.

Most people instantly think of gold, but I don’t believe gold is the best investment in inflation. Once again, gold is expensive to invest in and it doesn’t throw off cash. It will maintain its value over the long run, and that’s important, but other investments do better.

Commodities do well under inflation. Resource and mining companies tend to do even better. Land and real estate–as long as it’s not bought with debt–can hold up well in an inflationary environment. The things that do well in inflation tend to be tangible.

Stocks tend to do poorly in the initial stages of inflation, but then do outstandingly when inflation is brought under control. Once again, companies with pricing power do better. Companies with debt can do well as long as their debt isn’t floating (variable rate).

The problem, like with deflation, is getting the timing right. It’s not easy or even possible to do.

For that reason, I have a different approach than most to investing in a deflationary and then inflationary environment, especially because I know I can’t get the timing right on when deflation will turn into inflation.

First, I am buying high qualities companies with pricing power. They should fall less during deflation and should recover more quickly when inflation kicks in.

Second, I am buying companies with resource exposure as the market goes down. I can lock in better and better prices on the way down, and then really do well as inflation kicks in.

Third, I’m investing in foreign companies. When the dollar goes down for U.S. macro-economic reasons, that doesn’t mean other country’s currency will go down, too. High quality companies with pricing power in countries with more solid economics than the U.S. fit the bill here.

Finally, I’m caring more cash than usual going into this deflationary scenario. I will have cash as the market goes down and will be able to buy great companies, resource companies and foreign companies on the way down. It’s hard to buy low if you don’t have cash because you have to pick something that will probably have gone down a lot to buy something else cheap.

Deflationary and inflationary environments are tough to invest in, but there are smart options. Timing things perfectly can’t be done, so don’t try it. Investing to benefit from such an environment, however, can allow you to build tremendous wealth over the long run, and having a disciplined plan in place helps. Happy investing!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.