How to Navigate the Unavoidable 'Perfect Storm' of Inflation

An unexpected package from Dan Ferris... The best investment book you've never heard of... How to make sense of the market's guesswork... The surprising reason gold and silver could soar... How to navigate the unavoidable 'perfect storm' of inflation... The next 'Extreme Value 30' recommendation...

Several years ago, an unexpected Amazon package showed up at my home...

I (Mike Barrett) couldn't immediately tell who it was from or what was inside...

And I certainly didn't know that the package's contents would forever change the way I evaluate and invest in stocks.

Inside was a new copy of an older book (circa 2001) titled Expectations Investing, by economist Alfred Rappaport and investment strategist Michael Mauboussin.

I wasn't familiar with the book, but I was with the sender. My colleague and Extreme Value editor Dan Ferris suspected I'd find it useful.

Was he ever right.

Google "best investing books" and you'll get lots of great lists. But you're unlikely to see Expectations Investing on any of them. Yet it has had a profound impact on me.

I'm convinced it's because, before getting into this business, I first had a long career as a commercial real estate appraiser...

Like most professional endeavors, appraising large commercial properties such as hotels and shopping centers is a specialty...

It takes years of training and experience to "get it right."

But every appraisal, regardless of complexity, always starts with the same fundamental question: What will the cash flows of the commercial property look like over the next few years?

Imagine you're considering the purchase of a shopping center... Let's assume it's anchored by a movie theater whose lease expires in two years, and that the center also has many local tenants like takeout restaurants, a hairstylist, or nail salon.

Establishing the property's value today means you must first think through a number of crucial questions about how its cash flows will change over the next few years.

For instance, how likely is the movie theater to remain in business through the end of its existing lease?... And if they don't renew, how difficult will it be to find a replacement tenant for such a large space?

Are there better-located spaces already available in the area for new anchor tenants to choose from?... If so, how much will I have to lower the rent in order to attract them to this location?

Or, in today's climate, with the coronavirus outbreak and response temporarily shutting down non-essential businesses, how likely are the existing local tenants to ever reopen once the lockdown ends?

And how difficult will it be to lease the already vacant space in what's suddenly becoming a far more challenging market?

Imagining how the next few years are likely to play out for this hypothetical property is a painstaking, but necessary process...

Only then, once you collect the necessary data and properly analyze it, do dozens of decisions finally come together in symphony-like fashion using something called discounted cash flow ("DCF") analysis. (I'll explain what this means in a second.)

The point is, this was the world I came from when I made the transition from real estate analyst to stock analyst.

Early on, I read Robert Hagstrom Jr.'s The Warren Buffett Way, which introduces the basic DCF technique Buffett uses to value businesses. Unfortunately, it wasn't detailed enough to be of much use.

Then, Dan sent me Expectations Investing.

The model Rappaport and Mauboussin created is designed specifically for equities and turns conventional DCF analysis on its head. As they note in the book...

Rather than forecast cash flows, expectations investing starts by reading the expectations implied by a company's stock price.

The model exploits a huge structural that advantage equity investors have over their real estate counterparts... millions of buyers and sellers interacting each day to establish stock prices.

You probably don't think of them this way, but stock prices are really just the collective best guess of countless buyers and sellers...

And the guesses are about the timing and magnitude of future cash flows, based on incorporating all of the relevant information known up to that point in time.

The Rappaport and Mauboussin "expectations model" is highly valuable because it helps you deconstruct any stock price into three crucial valuation components... What buyers and sellers are currently expecting for... 1) Revenue growth, 2) Operating income, and 3) Free cash flow.

Take online retail behemoth Amazon (AMZN), which was recently trading around $2,300 per share.

Expectations analysis tells me at this price, investors believe revenue will grow about 18% per year, and generate operating and free cash flow margins around 7%, respectively.

Armed with this insight, now I can look closely at specific issues that are likely to play out in the years ahead, then quantify how they'll impact Amazon's valuation.

For instance, millions of people have made their first online purchases during this pandemic... What if Amazon converts many of them into new Prime customers and revenue growth accelerates to 20% or better?

At the same time, how will the addition of tens of thousands of new employees impact operating margins, as Amazon scales up to accommodate this new demand? (Related, I spoke on this topic in this video on "accelerating automation" in a post-COVID-19 world.)

Many investors aren't comfortable thinking about future cash flows on such a granular level...

I am fine with it, due to my commercial real estate background. This, combined with the expectations valuation model, gives Extreme Value readers an important edge, namely investment ideas others miss.

Let me give you two examples...

Since the first reported U.S. case of COVID-19 back in January, most stocks have been hammered.

One notable exception is a company we recommended last June...

It has a clear, competitive advantage in the retail space... and it actually turns into a better business during hard times. (No, I'm not referring to Walmart (WMT), which this company has actually outperformed over the last year.)

The stock Dan and I recommended wasn't particularly cheap by conventional metrics last June, so it was off the radar of many investors. However, we concluded it was approaching a growth inflection point and that the financials were very likely to improve over time, even if a deep downturn ensued.

To us, the shares were attractively priced.

Last month, our valuation model also helped us get subscribers into another high-quality business that investors were fleeing on virus-related concerns.

Investors were pricing in a substantial decline in revenue growth, as well as margin erosion over the next few years. But during the last two major downturns in 2001 and 2008 to 2009, neither of these things happened.

In fact, this business was one of the rare ones that continued to experience improved revenue growth and profitability during the hard times.

We expect that to happen again this time. Shares are up 16% since our recommendation, and are still currently trading below our maximum buy price as I write.

We see about 60% upside to our intrinsic value estimate.

Recently, I told Dan I've never been more excited about the Extreme Value portfolio...

I said it for several reasons, all stemming from a wide disparity between each position's expectations and upside potential.

Today, I'd like to share three more of our big investment ideas with you.

1. We've got a trio of "World Dominators" in buy range that sport above-average dividend yields...

Buying them in equal amounts would generate a combined average yield of 6%. That's three times the S&P 500 Index's dividend yield of 2.1%.

And this combined payout is growing about 5% per year, more than triple the current rate of inflation.

Good luck trying to find a higher quality yield with that kind of growth potential anywhere else – particularly with the Fed determined to keep rates ultra-low. If that growth rate continues, the yield "on cost" will rise to about 7.7% in five years.

2. We own the world's premier cybersecurity consultant, and its deep relationships and experience in the health care sector are about to pay huge dividends.

That's because the pandemic isn't the only problem hospitals and biotech companies are dealing with right now.

INTERPOL's Cybercrime Threat Response team recently said it detected "a significant increase in the number of attempted ransomware attacks against key organizations and infrastructure engaged in the virus response.

The pandemic has created the opportunity of a lifetime for a whole host of bad actors. The world suddenly has millions of newly remote workers unwittingly making mistakes that open their computers and company networks to hackers.

IT departments are being asked to secure company networks with skeleton crews... and like everyone else, hackers are on lockdown, sitting in front of their computers all day long.

All of this bodes very well for this leading cybersecurity business. The stock has held up remarkably well the past couple of months and is just under our maximum buy price.

3. Finally, I'm excited about Extreme Value because we have six different ways to own precious metals, four of which you won't find in any other Stansberry product.

One CEO recently said they haven't been able to keep up with surging demand. He also says this demand has been more persistent and broader-based than past gold bull markets.

As we've written in the Digest lately, we think there's a very good chance that gold demand will last. Here's why I think so...

A key watch point for precious metals investors is the trend in "real" interest rates, or the difference between actual (nominal) rates and the rate of inflation.

Real rates aren't supposed to be negative any more than the price of oil is supposed to be negative. But right now they are... The three-month Treasury bill yields 0.09%, but inflation (before seasonal adjustments) is 1.5%, producing a negative real interest rate of 1.4% (0.09% minus 1.5%).

This means investors are losing purchasing power by holding dollars in short-term treasuries. Whatever interest they earn is being destroyed by inflation.

So investors are doing what you'd expect them to do: trading more and more of their dollars for gold and pushing its price up to seven-year highs.

The question is, where do real rates go from here?

I think there's a good chance they go even more negative, like they did during the late 1970s.

Back then, as inflation accelerated, real rates turned deeper into negative territory and gold soared by a factor of four. Silver did even better, climbing about seven times.

If the same dynamic were to play out over the next few years, that means $7,000 gold and $110 silver aren't out of the question. Even if I'm just half-right, you definitely want to own both gold and silver, as well as their equities...

There are two big reasons the negative trend in real rates could worsen...

First, the Federal Reserve is determined to keep nominal interest rates low. To accomplish this, Fed chair Jerome Powell recently announced he'll buy U.S. debt in whatever amount is necessary.

In the past few weeks, Powell has made good on this promise, boosting the Fed's holdings of U.S. notes and bonds by more than $1.3 trillion, a staggering 67% increase year over year. With this kind of firepower, rest assured, Treasury yields will remain exceptionally low for as long as the Fed wants.

Second, inflation at the consumer level is poised to rise.

I know that sounds preposterous in a world where oil prices recently went negative. But keep in mind that energy prices have a relatively low importance in the CPI calculation: just 6.5% compared with 14% for food and 60% for non-energy services.

That's why a 2018 Fed study concluded the correlation between oil prices and CPI inflation is a weak 0.27 (the closer to 1.0, the higher the correlation).

In the late 70s, the catalyst for worsening negative real rates (and soaring gold prices) was a supply chain rocked by suddenly surging oil prices that was brought on by the Iranian revolution...

Back then, West Texas Intermediate crude rose 250% between 1978 and 1980. This energy inflation worked its way into many other prices and by March 1979, the CPI was rising an astounding 10%.

It peaked a year later near 15%, at which point the Fed finally raised nominal interest rates high enough to push real rates back into positive territory and end gold's bull market.

Today, the supply chain is once again being rocked, this time by the coronavirus pandemic...

When Chinese factories shut down in January and February to slow the virus's spread, this halted the production of many U.S. and European goods sourced in whole or part from China.

And there will be a lasting impact of this behavior...

As Elizabeth Economy, a senior fellow at the Council on Foreign Relations recently told the New York Times...

There will be a rethink of how much any country wants to be reliant on any other country.

France's foreign minister has already directed domestic companies to become less dependent on China, as well as other Asian countries.

In response, pharmaceutical giant Sanofi is launching a new company with 3,000 employees to manufacture active pharmaceutical ingredients ("API") at six sites across Europe.

Sanofi CEO Paul Hudson recently told Fortune...

Some essential medicines are hard to get in the pharmacy in Europe. Why? Because over time, we pressured the price to be so low, it could only be made in China or India.

Look for more and more U.S.- and European-based manufacturers to follow Sanofi's lead. Adding resilience to the supply chain has never been more important...

But moving suppliers closer to production and amassing greater inventories of key intermediate goods won't come cheap.

It's inevitable that as these incremental costs are incurred, they'll be passed on to consumers in the form of higher finished prices and push the CPI higher.

Tom Porcelli and Jacob Oubina, economists at global investment bank RBC Capital Markets, agree with me that the potential for supply-chain-induced inflation is real. Here's what they recently told clients:

It is not a stretch to think we could experience persistent and elevated goods inflation in the coming years...

Note that the main driver of [muted] U.S. inflation over the last two decades has been, without a doubt, globalization.

While core domestic-sensitive inflation over the last 20 years has averaged 2.7% (and above 3% thus far in 2020), core commodities inflation (ex.: food and energy) has averaged 0.0%.

A realignment in the global production relationship could see the latter drift closer to the former.

There's evidence food-based inflation is building as well. For instance, U.S. farmers are estimated in 2020 to have planted the fewest acres of wheat since records began in 1919.

Meanwhile, Russia, the world's largest wheat exporter, has temporarily suspended grain exports, due in part to the pandemic.

Throw in supply-chain issues and quarantine-induced stockpiling and you've got the makings of a perfect storm for inflation...

Declining supply plus rising demand translating into higher prices.

Finally, medical care services have a slightly larger impact on CPI than oil does, and these prices rose 5.5% in March, the largest of any single category.

In a post-COVID-19 world, it's not hard to imagine these prices rising even faster. Some hospitals and clinics are unlikely to ever reopen, while demand for delayed testing and elective procedures is likely to remain strong.

Again, couple declining supply with rising demand and you've got a recipe for higher prices.

In short, the Fed is determined to keep nominal interest rates exceptionally low, and non-energy prices are likely to continue rising. Put the two together and it's just not that hard to imagine real rates turning deeper into negative territory.

If it materializes, this could push gold and silver to new heights. And this is a key reason we've got six high quality gold and silver ideas in the Extreme Value portfolio.

The most important job of every investor 'is to strike the appropriate balance between offense and defense'...

That's what investing legend Howard Marks noted in a recent essay.

Dan and I couldn't agree more.

Since 2017, we've clearly favored defense over offense.

But now that the broader market has suddenly gotten much cheaper, we're shifting to a posture that favors offense.

In April, Dan and I made the first buy recommendation from our "Extreme Value 30" watch list. On Friday, we'll make the second.

The Extreme Value 30 watch list is the ultimate offensive weapon...

It's made up of businesses that rarely go on sale or show up in a Stansberry newsletter... and we've spent months compiling it and studying the companies that comprise it.

These 30 businesses have exceptional brand loyalty and annuity-like free cash flows...

And we're using our proprietary "expectations" methodology to track their share prices in relation to intrinsic value.

When the discounts get wide enough our subscribers are the first to know... like with our last recommendation.

As Dan said so well in the April 3 Digest...

In November 2008, I wrote an issue of Extreme Value called "No Time For Chickens."

And now, almost a dozen years later, here we are again.

If you're not already joining me for this ride, I hope you'll consider doing so today...

To learn more about a subscription to Extreme Value, click here now.

And thanks Dan, again, for the book.

COVID-19 Myths: Debunked

Health & Wealth Bulletin editor Dr. David Eifrig joins our colleague Jessica Stone to dispel several rumors about the science of COVID-19. Check out the insightful video here...

... And be sure to check out Stansberry Research's YouTube page for much more video content from our editors every day.

New 52-week highs (as of 5/4/20): Calibre Mining (CXB.TO), Franco-Nevada (FNV), Barrick Gold (GOLD), MarketAxess (MKTX), and Wheaton Precious Metals (WPM).

In today's mailbag, a comment on the statement in Monday's Digest about the difference between gold's "price" and "value." Do you have a comment or question? As always, send it to feedback@stansberryresearch.com.

"I disagree with your statement that the value of gold does not change, only the price does. I'm pretty sure both the value and the price change over time. To me it's just like if you own a house free and clear the house just sits there, but its value changes depending on market conditions. If the house is sold the price paid may not match its value. Sometimes buyers overpay or sometimes they find a bargain. The value is what it is but it does not remain static.

The relationship between value and price is that current value at any time is dependent on the price buyers are willing to pay. It would not make any sense to say the value of an ounce of gold is $500 if no one is willing to pay that much. Likewise if buyers are willing to pay $800 per ounce it would not make sense to say the value is only $500." – Paid-up subscriber John M.

Regards,

Mike Barrett Orlando, Florida May 5, 2020