How Investors Can Fend Off Inflation, According To Christopher Zook

Christopher Zook thinks the risk-reward in the market is the worst he’s seen in his 30 years in the business.

Zook, Chairman and Chief Investment Officer for Houston-based CAZ Investments, wants to protect his clients from the market sell-off he believes is inevitable. In this exclusive interview, he reveals some strategies to insure an investor’s portfolio against downside risk.

The following interview has been edited for content and clarity.

Karl Kaufman: What are the major risks right now?

Christopher Zook: Something is going to give. One possibility is tremendous earnings growth due to hyperinflation. That will create a significant increase in interest rates, dramatically impacting valuations.

The other possibility is a weakening economy, causing earnings to come down. Or worse, we have stagflation, which we haven’t seen since the 70s. With stagflation, there’s not only inflation but also stagnation of the overall purchasing power of consumers and the pricing power of corporations. That causes massive compression of margins. 

Margin compression leads to multiple compression. That’s a real possibility right now, depending on how this monetary tsunami plays out when the Fed starts taking liquidity out of the system.

We’re hedging our portfolio against a potential sell-off. If the markets keep rising, the insurance cost will become negligible in the overall scheme of things.

Kaufman: How then should an investor structure their portfolio?

Zook: Investors are stuck: it’s a very expensive stock market and a very expensive bond market. It’s hard to know where to put capital. If you don’t earn enough of a return, you’re negatively affecting your purchasing power. 

The challenge for investors is where to put that ‘safe money,’ where they’ll get a real rate of return after inflation. Unfortunately, the old 60/40 model is dead. 

It was fine in a different interest rate environment, and it’s statistically sound. But it doesn’t work when there’s not enough opportunity to protect oneself from the bond portfolio, compared to the risk in the stock portfolio. 

Going to cash, obviously, is a horrible real rate of return. 

Investors are left trying to figure out what has predictability and less correlation. Unfortunately, they really are stuck. Investors have to design a completely new risk mitigation strategy to protect their portfolios in a time when the market is the most expensive it’s ever been.

In a post-pandemic world, they need a post-pandemic portfolio that protects against the decline, generates some cash flow and serves as a buffer when the market sells off.

With just a portion of their portfolio, they can mitigate most of the risk. They’ll have solid protection in place against that kind of eventuality in a way that ultimately doesn’t really cost them anything. 

Imagine buying home insurance and getting paid for having that insurance. That’s what someone should look to accomplish.

Kaufman: How can investors insure their portfolio?

Zook: In the credit market, there are pockets of opportunity. It’s not plain vanilla, traditional, or an ETF – it needs to be more opportunistic and differentiated. It should be managed by people who can navigate the storm that will inevitably happen, either because of a recession or hyperinflation.  

Investors need to find talented credit managers to manage that portion of the portfolio while building an insurance policy for their portfolio that protects them against a March 2020 or a 2008-09 scenario. 

That way, they can sleep at night and can invest the risk portion of their portfolio however they would like. They’ll know they have that risk mitigated by the way they’ve positioned a part of their portfolio.

There’s the ability to generate solid yield without taking too much risk in private credit. There’s the leveraged loan market, the private credit market. It’s not traditional private equity; it’s a much more liquid, much shorter duration opportunity. They may not have daily liquidity, but they’re not going to have to tie their money up for 10 or 12 years like you would in traditional private equity. 

They may choose to go into private equity to get good yields and solid returns, but they can only do that with a portion of the portfolio they’re willing to have no liquidity. 

For the portion of their portfolio that they want to have some reasonable levels of liquidity, they can do that in private credit or some non-traditional fixed income spaces.

Kaufman: What’s the best financial advice you’ve ever received?

Zook: If you want to have what others don’t have, you have to be willing to do what others don’t do. 

That means you have to think differently, think outside the box, and be prepared to go against the trend. The vast majority of people in this world never get what they want because they never are willing to do what it takes to get it.