The Triad Perspective
     


Markets have made a strong move higher since mid-June. Since our last issue, both the S&P 500 Index and the small cap Russell 2000 Index each rose about 5% through yesterday's market close. 

The big news during this period was Brexit, which lopped a little over 5% off of the S&P 500 Index in 2 days late in June.  Though it will have significant impact to the UK and Europe, in the end it doesn't materially change our appraisals of company value.  In our opinion, most well-managed businesses should actually be able to prosper from the changes ahead.  That is an advantage in seeking to invest in a select number of businesses with able management teams vs. buying a broad market index fund or ETF that is forced to own companies run by both the able and, frankly in our view, not-so-able.

If you ask the government, inflation hasn't been much of a factor for quite some time, and in fact deflation seems to be on the minds of policymakers.  Our observations tell a different story, with evidence of rising inflation all around us.  If this is correct, this has ramifications for investors flocking to investments promising price stability and yield.  We explore this phenomenon in our essay below.  


John Feb 5
John Heldman, CFA
Partner | Portfolio Manager




Dave Hutchison, CFA
Partner | Portfolio Manager

InflateGate

I'm quitting.  Not my marriage, business, hobbies, or anything like that.  No, I'm talking about more important stuff (just kidding, honey).  I'm quitting Starbucks. 
 
My long love affair with a morning purchase of a large--sorry, Venti in Starbucks-speak--coffee is over.  By the way, Starbucks, why is your small coffee called Tall?  But I digress.  Last week when I conducted my morning coffee buying ritual, I noticed the price had increased 8% from $2.45 to $2.65 for a large/Venti coffee.  I know, it's peanuts, not a big deal.  Of course that's what Howard Schultz--top Barista at SBUX--is counting on.  People probably won't notice. 
 
I did.  Actually I've noticed most of the previous price increases.  If I recall correctly it wasn't that long ago that I was paying about $1.85 for the same large coffee.  Howard is raising prices far above the "official" inflation rate of around 1% per year.  Why?  Because he can.  It's a low dollar, daily purchase of a highly habit-forming substance.  What a great business!


 
Starbucks isn't the only company that's raising prices these days.  Despite the headlines that the U.S. Federal Reserve is concerned about inflation being too low, most everything in my world is headed in one direction--up.  My haircut recently increased from $18 to $20, or 11% (some of you are snickering that you tip your stylist that much; I patronize Supercuts, the McDonald's of the haircut industry).  Going to the movies?  That'll also cost you more; up to $20 in some locations.
 
How about college costs?  I paid for our 2 kids to attend a private college.  Thankfully, they're done.  The cost went up reliably about 8-10% every year.  I even asked the school President about the increases one year.  He explained that many school expenses were up; professor salaries and the like.
 
Home prices are another area where I see nothing but increases.  Or even apartment rental rates.  More increases.  How about automobiles?  Have you priced one lately?  According to Kelly Blue Book, the average price in 2016 is $34,000 per car or truck.  Yes, some of this is due to government-mandated improvements in safety and fuel economy, but still, that's almost twice what my parents paid years ago for the home I grew up in.
 
To use an overworked phrase, "What's the key takeaway?"  Don't put a lot of faith in the inflation statistics you see.  While much of my experience is just my own and anecdotal, and other items such as clothing and electronics prices routinely decline, it should make you wonder if inflation is really higher than what is reported.  In my view it is, and if I am correct, it has implications for the investment world as well as the "real" world.
 
Investors today are desperate for income-generating investments.  Strong demand for income has pushed up the prices for these investments.  So, Mr. or Mrs. Investor, beware of long-term bonds paying paltry 2%-4% rates of income.  If inflation rates are seen to be higher than official statistics, interest rates will need to rise to offset the higher inflation.  Rising interest rates mean bond prices go down.  For example, say you own a 10-year U.S. Treasury bond currently yielding around 1.5% interest.  If market yields rise to 3.0% over the next 2 years, the price will drop around 10%, offsetting almost 7 years of interest payments.  Longer-dated bonds would perform much worse.  In this environment of historically low interest rates, I have two words of advice: be careful.
 
In the bad old inflation days of the 1970's when inflation was double digits and bond prices only went down, investors would refer to bonds as "certificates of confiscation", meaning real wealth was eroded or "confiscated" as inflation eroded the real purchasing power of their fixed income payments.  While it seems unlikely we will return to those days, it's worth remembering a bit of history and making sure you aren't taking outsize risks to capture a bit of income.
 
By the way, I'm not giving up coffee.  I'm just going to make it at home for a lot less.  My personal inflation rate will at least go down a bit.  Take that, Howard!

-John Heldman, CFA
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Triad Investment Management is a 100% employee-owned SEC-registered investment adviser.  We serve families, individuals, & foundations.  Triad manages all-cap, small-cap and balanced portfolios with a focus on Research, Behavior and Ethics.  We serve as the Adviser to the Triad Small Cap Value mutual fund (symbol TSCVX).  Learn more at www.triadim.com and www.triadfunds.com.
 

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