Theonlytroubleis,itsalsoprobablythehardestinvestmentcalltomakerightnow。

Andsoweneedtothinkabouthowwecanminimisethedownsideifwegetitwrong…

Inflationordeflation–wecantbesure

Itsstillatoughcallastowhetherwegetinflationordeflationincomingyears。

Illlookatitinmoredetailinafutureemail–butthepointisthatitsimpossibletobesure。

Sosmartinvestorsshouldbethinkingabouthowtominimisethedownsideiftheyrewrong。

Letstaketheexampleofequities–inparticular,letslookthetwotypesofleverageacompanycanhave。

Thesearefinancialleverage(itsdebtburdenanddebtservicecosts);andoperatingleverage(howitscostsadjustinresponsetoachangeinsales)。

Acompanywithlowfinancialandoperatingleveragewillcopebestunderdeflation。

Itsrevenuesmayfall,butithaslittledebttoserviceanditsproductioncostsshouldalsofall。

Sotheimpactonitsprofitsshouldntbetoosevere。

Forexample,a5%fallinsalesmightmeana10%fallinprofits。

Ahighlyleveragedcompanyisinamuchworsesituation。

Withsomanyfixedoutgoings,a5%fallinsalesmightbeenoughtoplungeitintoaloss。

Underinflation,ontheotherhand,wehavetheoppositeoutcome。

Becausesomanyoftheleveragedcompanyscostsarefixed,risingpricesforgoodsitsellstranslatestraightintoprofits。

A5%salesrisemightbeenoughtoboostprofitsby50%,forexample。

Meanwhile,moreofthelow-leveragecompanyscostswillriseinline,sothata?

5%salesrisewillonlymeana10%profitincrease。

Thissuggeststhatifyouexpectdeflation,yourportfolioshouldbebiasedtowardslowleveragecompanies。

Meanwhile,ifyouexpectinflation,youshouldleantowardshigherleverageones。

(NotethatImtalkingaboutmoderateinflationhere,notaseventies-stylewage-pricespiral–inthis,mostcompanieswillsurvivebuttheirshareswilldobadly。

)

Buttheresasnag。

Whatifyourewrong?

Ifyoubiasyourportfoliofordeflationandyougetinflation,yourstocksshouldstilldowell–justperhapsnotaswellassomemoregearedones。

However,ifyoubiasitforinflationandyougetdeflation,youcouldbeinserioustrouble。

Theverysurvivalofhighlyleveragedfirmswillbeindoubtintoughdeflationaryconditions。

SoeventhoughIexpectmoderateinflation,Idontwanttobeoverexposedtoleveragedfirms,incaseImwrong。

Now,obviouslythisisnttheonlyconsiderationwhenselectingstocks。

ImhappytoownmoreleveragedcompanieswhenIcanbuythemcheaplyenoughsothattherisk/rewardtrade-offisgood。

Butitsanimportantfactortotakeintoaccountwhenlookingattheoverallshapeofaportfolio。

Ifyourportfolioistoogearedtoinflation,thinkaboutaddingsomelowerleveragestocks

Anout-of-favourstockthattickstheboxes

OnecandidateIlikeisvideogamesgiantNintendo(TYO:7974)。

Thefirmhasnodebtandacashpileof¥749bn(US$8。

25bn)。

Andotherthanin2005–whenitwasrampingupformajorproductlaunches–operatingleverage(measuredherebypercentagechangeinoperatingtoprofittopercentagechangeissales)hasbeenlow。

Nintendosoperatingleverage

Rightnow,thestockisdeeplyoutoffavour。

Ithadanexcessiverun-upinthelastfewyearsasinvestorsgotcarriedawaybystrongsalesofitsWiiconsole;nowassalestailoff,everyoneisbailingout。

Nintendoisoneofthefewstocksthathasntparticipatedatallintheglobalrally,asyoucanseebelow。

Nintendosshareprice

Bothhardwareandsoftwaresaleswereoffsharplyinthefirstquarterofthisyear。

Thatwaspartlydowntotheglobalrecession,butabiggerproblemisthatasignificantnumberofthepotentialcustomersforboththeWiiandthehandheldDSconsolehavenowboughtone。

Meanwhile,softwarereleasessofarthisyearhavegenerallybeenlessexcitingthanlastyear。

Theanalystsconsensusthatprofitswillstillrisethisyearlookshardtojustify,andthemarketclearlyexpectsthemtobeprovedwrong。