In part 1 of this series, we saw why even periods of high inflation aren’t necessarily bad for stocks. In fact, the worst inflationary period in US history actually saw stocks deliver positive real returns (despite three bear markets) and REITs blew the cover off the ball with 7% real returns.

In part two of this series, we’ll explore why stocks are historically the best inflation hedge and what kinds of companies, in particular, tend to do especially well during periods of high inflation.

Why Stocks Are Historically The Best Hedge Against Inflation

Many investors assume that Gold is the best inflation hedge. That might seem intuitive, but it’s not actually true.

Actually compared to even government bonds gold has vastly underperformed.

And guess what has done the best? Stocks and REITs just as saw in part one of this series.

(Source: Charlie Bilello)

Adjusted for inflation, gold has delivered 1.4% annual long-term returns, about 1/3 that of bonds, and more than 6X less than stocks.

The reason for this is that gold is a commodity. It generates no income, and thus there is no reason to believe that its price will naturally rise over time.

If gold prices rise quickly, miners increase supply and the prices stabilize or decline.

In contrast stocks, including REITs, are living companies, run by adaptable management. When anything bad happens management does what it has to preserve margins, including raising prices to offset inflation.

This is why REITs did so well in the 1970s. Which brings us to the question many investors have, what are the best stocks to own in inflationary environments?

The Stocks That Do Best During Inflationary Times

All stocks in general do tend to do well when inflation is high. REITs and utilities also tend to do well, because their lease or regulators directly allow them to pass on higher costs to customers.

Financials can also benefit from rising interest rates expanding yield curves and acting as a tailwind for profit growth.

However today many utilities are overvalued. Some of the most popular REITs are as well.

But do you know what’s the opposite of a bubble? Anti-bubble blue-chips and the mother of all anti-bubble blue-chips is consumer staples giant British American Tobacco (BTI).

(Source: JPMorgan Asset Management)

BTI’s pricing power, thanks to its strong brands, is so great, that JPMorgan’s blue-chip economists think that it would outperform the S&P 500 in an inflation spike scenario by 14%.

Of course, soaring inflation is not actually likely right now.

The bond market is expecting long-term inflation of about 2.1%. In the short-term 2.5%. In March core producer prices rose by 3%.

These are hardly inflationary levels to be concerned about. For context from 1974 to 1981 inflation averaged 9.6% and from 1978 to 1981 11.6%. In 1979 it peaked at 13.5%.

Rather what gets me excited about BTI, whatever happens next with inflation, is the valuation.

BTI is about 49% undervalued, literally the best anti-bubble, blue-chip bargain on Wall Street.

Here is a reasonable idea of what kind of returns you can expect buying BTI today.

BTI 2023 Consensus Return Potential

(Source: F.A.S.T Graphs, FactSet Research)

If BTI grows as analysts expect through 2023, and returns to historical fair value, then analysts expect

• 115% total returns (more than double your money)
• 32.3% CAGR returns (Joel Greenblatt levels of returns)
• vs -1.4% CAGR S&P 500

BTI at its 49% discount has the potential to outperform the S&P 500 by 119% over the next three years.

(Source: F.A.S.T Graphs, FactSet Research)

Over the long term, BTI’s return outlook is also far more attractive.

BTI 2026 Consensus Return Potential

(Source: F.A.S.T Graphs, FactSet Research)

If BTI grows as analysts expect through 2026 then investors can expect

• 170% total returns
• 18.9% CAGR
• vs 4.4% CAGR S&P 500
• 4.3X better than the market’s consensus return potential

(Source: F.A.S.T Graphs, FactSet Research)

Over the long term, analysts expect

• 7.7% yield + 4.6% growth = 12.3% CAGR very long-term total returns (after valuation changes cancel out)
• 10.7% to 15.7% CAGR range
• 14.7% to 16.7% based on management guidance
• vs 7.9% for the S&P and 10.6% for the dividend aristocrats

(Source: Portfolio Visualizer)

BTI has been through 8 bear markets since 1986. Each time it created the opportunity for incredible market and aristocrat smashing returns over the next 5 to 15 years.

That’s the case today, with BTI still offering a valuation that prices in zero growth. Even if it achieved zero growth, buying today would lock in 7.7% returns for years if not decades.

And if it grows as expected, or as management expects, then patient long-term investors who are comfortable with the risk profile will get rich.