In His Estimation, Stagflation -- but Money Manager Finds Way to Profit

Some say deflation.
And some say inflation.
Some say recession.
And some say stagflation.

Let's Call the Whole Thing Off

"As I indicated in my remarks to the Financial Services Committee, we think inflation at the moment is very well contained. The problem we see is not an immediate emergence of inflation pressures."

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Or so said Federal Reserve Chairman Alan Greenspan before the House Budget Committee this past Friday.

With all due respect to the Fed chairman, we continue our recent efforts to examine whether inflation should be a concern. Since this column first raised the recession-obsession theory on Feb. 1, economic data have supported the notion the economy may indeed have already seen its nadir.

The new Chicago Fed National Activity Index also hinted as much on Monday, but there's obviously a lot more data to go before a final tally can be reached. Tuesday, the productivity report showed that productivity had fallen in the fourth quarter, but unit labor costs had risen, another potential inflationary sign.

Here's the thinking: There will be stimulus from both monetary and fiscal policy, and this could come at a time when the economy is already recovering, which could spark inflation.

Meantime, we again ask the question: If (if!) inflation is going to re-emerge, then where/how to invest?

After reading about the big European steelmakers combining efforts and U.S. Steel (USX - Cramer's Take - Stockpickr) seeking to implement price hikes last week, I called Dwight Anderson. A year ago, when I was (ahem) writing about how value stocks might outperform growth in 2000, Anderson described how production capacity in many basic industries was falling due to consolidation and outright shuttering of facilities. Those decisions were made after years of falling demand and prices. But because it's not easy to quickly restart, say, a smelting plant after it's been shut down, prices will rise even if demand merely stabilizes. If demand accelerates, so will prices, until capacity gets back into equilibrium -- which can take years. Or so the theory goes.

Anderson runs the Ospraie Funds, a basic-industry-only hedge fund, for Tudor Investments. He declined to discuss Ospraie's performance or size, but a source familiar with the fund said it produced returns after fees of over 20% last year and now has over $250 million in assets. I couldn't independently confirm those figures, but can confirm Tudor Investments doesn't make a practice of creating new funds for employees (as was the case with Anderson) unless they are highly competent.

From a macro viewpoint, Anderson contends the thesis described above remains very much intact. "Aluminum [prices] would be 10% lower," he said, if Alcoa (AA - Cramer's Take - Stockpickr) hadn't cut 70,000 tons of output at a Washington state smelting plant, which it recently sold to Michigan Avenue Partners.

Still, the hedge fund manager isn't terribly concerned about inflation, calling a recession -- in which demand falls and commodity producers can't sustain pricing -- a "legitimate risk here." But he does believe that as the U.S. continues to shut down capacity in basic industries, we're going to have to import more materials, which might have a negative effect on the dollar and lead to higher commodity prices. He believes stagflation -- a period of declining economic output accompanied by higher prices -- is not only a legitimate risk, but exists today in some parts of the economy.

The possibility of recession vs. the potential for inflation or stagflation might sound confusing, but Anderson believes there are still tremendous opportunities in the basic-industry sector. Because of the recession threat, the key is to invest in the lowest-cost producer in a given industry to protect yourself from potential downside in pricing, he said. If prices rise, you will still enjoy the windfall.

Notably, most of the low-cost producers in basic industries are not domiciled in the U.S., which is the world's "high-cost producer," mainly because of labor costs and the nation's inefficient energy policies. "Our companies are either going to be up sixfold or bankrupt. It's a lottery ticket," he added.

Some of Anderson's international favorites trade on U.S. exchanges, including Sappi (SPP - Cramer's Take - Stockpickr), a South African paper company, and WMC (WMC - Cramer's Take - Stockpickr), an Australian miner of nickel, gold and uranium. He also likes a trio of Canadian firms, including Talisman Energy (TLM - Cramer's Take - Stockpickr), an independent oil and gas exploration and production company, Agrium (AGU - Cramer's Take - Stockpickr), a fertilizer maker, and Methanex (MEOH - Cramer's Take - Stockpickr), a chemical concern.

For those who prefer to invest only in U.S.-based companies, Anderson remains most favorably disposed on small- and mid-cap energy names. In addition to Talisman, he likes Murphy Oil (MUR - Cramer's Take - Stockpickr), DevX Energy (DVXE - Cramer's Take - Stockpickr), Ocean Energy (OEI - Cramer's Take - Stockpickr), Chesapeake Energy (CHK - Cramer's Take - Stockpickr) and -- among larger firms -- Occidental Petroleum (OXY - Cramer's Take - Stockpickr).

Late last week, Ospraie Fund was long all of the aforementioned stocks.

As for gold -- which has been talked about recently in some circles (albeit in hushed tones) -- Anderson professed to be agnostic. While attracted to cost-cutting efforts taken by the industry and the "huge short interest" in the metal, he called gold an "anachronism" because all of the metal that's ever been mined remains in circulation. Bottom line: "I'd rather not touch something I don't have a firm view on," he said.

As Allan Sherman once sang, that's Good Advice for just about any investment.

You Say Tomato

For the record, I'd like to avoid having Luskin vs. Task become a preliminary bout to the Cramer vs. Eavis inflation vs. no-inflation main event.

Still, it is disingenuous to say "nobody" is worried about or talking about deflation, because deflation has been a buzzword among economists and pundits since the Internet hit critical mass in late 1995. That said, I don't believe hyperinflation -- when prices rise 100% or more and the local currency collapses -- is a threat and agree some inflation is preferable to deflation, particularly the kind that's infected Japan for the past 10 years.

By focusing on the potential for inflation's revival, my intent is -- as always -- to give readers as many points of view as possible and to alert you to risks/opportunities you might not otherwise consider. It is not (repeat: Not) my job to tell you what to do with your portfolios, but to (hopefully) help you make better and more informed decisions.