A Deflation-Resistant Stock: Is There Such an Animal?

As the US recovery sputtered, the Fed first cut its forecast for growth and inflation, then Ben Bernnake told us the macro outlook was “unusually uncertain”, and now the Fed has reversed the course set in place to wind down a balance sheet already triple its normal size at $2.3 trillion; trumping the inflation scenario and sending investors scurrying into the deflation camp and fleeing “risk on” trades. Hattip to the deflationists. One could point out that deflationists have not had their prediction (i.e., real deflation) come true for the last 50 years, but rather than fight the tape (and the Fed), now-contrarian inflationists will just have to go with the flow for now i.e., reduce equity and commodity exposure and go long VIX volatility, bonds, gold and cash while waiting for the next turning point. With the S&P 500 failing to hold its 200-day moving average and now testing its 50-day moving average, we’ll have to see if support at 1,060, 1,010 or 900 holds.

For Japan, this means strong momentum for new highs on JPY/USD below JPY/USD80 despite an increasingly expected response by the Japanese government, and downside on the Nikkei 225 of about 11% to the 8,000 level i.e., the opposite of our “next 15 minutes of fame” scenario in which Japanese equities stage a meaningful rally. With Japanese JGB yields having historically been as low as 0.44% and JPY/USD still pushing historical highs, both foreign and domestic investors are likely to keep money parked in JGBs until the deflation hysteria passes. Our point remains however that once JPY/USD peaks, it won’t stay there long. When JPY peaked at JPY79/USD in 1995, it almost immediately began falling, and crashed to the JPY/USD140 level by 1998.

Investors now steeped in deflation psychology are beginning to look to Japan for guidance on what stocks could hold up during a major bout of deflation. We have identified 47 Nikkei 225-constituent stocks that have dramatically out-performed both the MSCI USA and EAFE indices since Q3 1998 during Japan’s deflation. Further paring this down by selecting those that, a) dramatically outperformed the US and EAFE indices, b) have ROCE (returns on capital employed) of over 8% and c) have lower (under 13X) EV/EBITDA ratios, gives us a compact list of 11 stocks that should continue to do well under Japan’s ongoing deflation.