productive, resource, and financial assets: it may be important to differentiate between them
My name is Checklist34. I made an absolute fortune by betting big on financial stocks over the last 11 months. I still think, and I do apologize for the immodesty here, that is the best call on the markets I remember reading in 2009, and maybe the most profitable. It has, for anybody who has read my blogs over the last year, been no big secret that my portfolio is poorly diversified and massively laden with financials. >50% in financials.
So i'm way long financials (with some hedges). And I am now going to make an observation about how this is a potentially significant weakness in my portfolio... besides the obvious risk of these stocks being highly leveraged to the markets overall (another market crash would kill them once again)... they represent a form of being long the US dollar. I'll explain below.
I would like to, for purposes of this discussion, break equities into 3 categories. These are productive stocks, resource stocks, and financial stocks. I'm not 100% sure what category retail stocks would fit in, so lets just forget about those for purposes of this discussion. Service companies are also a bit of gray area, but quite often probably fall into the "productive stocks" category. REITs additionally represent a bit of gray area, but DO NOT fall into the "financial stocks" category as defined below.
Resource stocks are companies like TCK, or maybe AA, or FCX, or whatever. Miners, oil companies like Exxon, a company like CHK, and so forth. They get stuff out of the ground and so on, they derive their revenue from natural resources. Another category of companies that I would consider adding to the resource stock list would be some agriculture companies. Other ag companies would be productive stocks...
Productive stocks are companies like DOW or DD, or F, or MON or INTC etc etc etc etc etc. They make stuff, they offer services at times. Manufacturing, relevant services like those offerd by IBM etc. Pretty simple category here as well...
Our third category, for purspoes of this discussion, is financial stocks. The assets of these companies are generally in fiat currency, in my case for the vast majority of the financials I own, they are in $US. US Dollars. Their income streams, in general, are interest derived. Banks, BDCs, insurance companies come to mind.
OK, simple enough. Now for the next part of this discussion. Lets look at 4 companies that I own. DOW, Dow Chemical, a produtive stock. TCK, Teck Resources, a resource stock, and XL, XL Capital, a financial stock (insurer) and ARCC, Ares Capital, a financial stock (BDC, a lender).
DOW has revenue of about $50-60B in normalized times, that is about 0.4% of GDP. Its assets are primarily productive ones, plants, equipment, and intellectual property. If we experience massive inflation... DOWs revenue is likely to remain about 0.4% ofGDP. So the value of the dollar halves, overall economic activity goes up 10%, GDP gravitates to ~$30B, DOW is likely to bcome a $100-120B company. all rough crappy math. Its equity price is likely to rise with inflation in the fullness of time, as equities have for most of recorded history, eventually (its not a smooth rise certainly).
TCK has revenue in $Canadian, and produces resources. We need steel, TCK mines coking coal, our need for that isn't likely to decline. So like DOW, TCK is likely to rise with inflation over time. But in this case with $CAD as its currency it may stand to respond even better than a productive company - or at least quicker - to commodity inflation.
XL has revenue from primarily fixed income sources and writing insurance premiums. Say its book value is $25/share and the dollar gets cut in half by inflation... That book value is now worth $12.50 in todays dollars, while DOWs revenue stream grew the value of debt assets on insurance company balance sheets will not grow with inflation but rather will depreciate in dollar terms unless held to maturity with rising interest rates. Their ability to generate revenue by writing premiums would have ability to rise with inflation. If a company or person is willing to pay X% now for insurance protection, they are likely to remain willing to pay x% in the future for it. But the vast value of XLs investment book today - practically all bonds and other forms of debt - would be damaged. XL and the insurance market in general, could raise insurance premiums fairly quickly.
ARCC has revenue, lets just say for the heck of it, only from debt. It can generate new value from writing new loans. In a situation where we experience rapid inflation the value of its current book would be diminished much like XLs. And like XL it could only raise revenues over time by lending higher dollar amounts to companies. If you are a company that has $10mil of revenue today and you need $1mil in a loan to fund growth, in our future inflationary environment you would be a $20mil company needing $2mil (10% of revenue in each case, which would buy the same things in each case). But ARCC cannot raise the amount of loans it has out quickly at all. Each loan is paid back in a fixed amount of $$, and that fixed amount of $$, upon the loan being repaid, is all that ARCC would have to reinvest at some future time. So 2 of its loans made today for $1mil would be required to make one equivalent loan in our hypothetical future situation where everything has doubled in price.
So we see here some interesting things...
First, as the dollar weakens, TCK benefits immediately. Its product is sold in $CAD and it is first in line to see prices for its products rise. Witness the huge spike in commodity stocks during the weak-dollar periods fo the last coupld years.
Second, in time (however unsmooth it goes at the beginning), DOW can and would raise prices to pass inflated commodity prices on to its customers. Probably be ugly at the beginning... but eventually DOW would not suffer in inflation.
Third, a company like XL could raise insurance premiums to match the now-inflated environment, but its existing book would be permanently damaged.
And last, a pure finance company like ARCC would wind up most pinched by a rapid fall in the dollar. Because with the price and cost of everything going up its customers would require loans more more $$, and ultimately Ares would only have a fixed and fairly slow to grow amount of $$ available to itself to invest.
So... maybe we see a bit of a playbook for the onset of significant inflation. When it hits you'd want to be in resource companies, then shift to productive companies as prices of resources stabilize to benefit from them getting caught up to the change and... holders of financial stocks may suffer during periods of rapid inflation.
The flip side for financial stocks, of course, is that inflation would inflate the value of hard assets collateralizing their loans. We have seen the hellish havoc that sudden deflation - and the associated drop in the value of these hard assets used as collateral - can have on financial stocks... so maybe financial stocks are difficult to own in any environment where we see rapid changes in the value of the currency in which they deal.
But, assets used as colalteral aside, financials seem to be better suited for stable-currency or strong-currency environments than weak currency ones. And this may be a weakness in my portfolio... if we get strong inflation at some future time. Which I consider basically inevitable as its the simplest way out of the national debt problem.
And, so... maybe we have some lessons here. REITs > BDCs for dividend/income plays in a case where significant inflation is occuring and maybe productive dividend payers like VZ, T, or MO should also be considered in lieu of BDCs for a portion of a portfolio hoping to generate income if one expects an inflationary environment or dollar depreciation.
Something I need to consider and ponder at great length...