Finding inflation-beating companies is about more than just pricing power
The world is getting a lot more expensive. In the U.S. prices rose 7% in the year to December - the largest 12-month gain since June 1982 - while here in Australia that number is slightly more muted at 3.5%.
The scourge of inflation is sure to cut into company profits, as they struggle under the weight of higher input costs, higher wage costs and higher borrowing costs.
Companies with pricing power that are able to pass on these higher costs will keep their heads above water. But as Intermede Investment Partners CEO Barry Dargan explains in this wire, pricing power isn't the only inflation-beating attribute he looks for when investing.
He also provides insight on central bank responses to inflation, and where he comes down on the value versus growth stock debate.
How are you positioned if inflation becomes structural?
Barry Dargan: The sort of companies we own are companies that have very strong pricing power and so if we do get into a situation where inflation becomes endemic, as may well be the case, these companies will be able to pass on inflation to either to consumers or to their customers.
Many of companies that we own are actually companies that don't charge anything for their product, so things like social media companies where essentially the people that pay them the money are B2B.
It's companies buying advertising on their space and you know, that sort of cost can definitely be passed on.
Some companies are ones that charge a very small amount relative to the transaction that they're offering. So an example of that would be something like CME, where if you're trading, let's say a million dollars of futures, you're only being charged about a dollar by them to do that. And so, again, it's almost an invisible cost.
Then a lot of other companies that we have are essentially very difficult to really figure out that even prices have gone up. So something like Accenture, which is doing sort of a must have project on taking a company to the cloud. If they are working on a project, it's very difficult to tell that perhaps the project is costing a little bit more this year than it might have done last year. So the sort of companies we own have very strong moats around their business. They're very well protected, as it were in terms of their franchises, and so will do well in that kind of environment.
Are central banks doing enough to combat inflation?
So the supply is somewhat restricted by the fact that a lot of things like restaurants might have shut down, or shops might have shut down because of the pandemic when they weren't able to do business, so there's less of those around. And then supply chains that largely come out of Asia have also been impacted by the fact that they've been in lockdowns as well. So we've got a bit of a supply shortage, meeting sort of a demand surge, so there's no question that at least some of the current inflation is temporary and that will roll off once we get back to a more normalised situation. People get back to having normal spending patterns and supply chains come back up. And then also we get things like new restaurants opening and what have you.
So we will get back to a more normal situation and central bank action at this stage, I think has to, clearly has to take that into effect and I think they do. But beyond that, I think we're probably in a slightly more inflationary environment than we were going back the last few years, by which I mean, probably something in the light, in the region of maybe two to 3% annual inflation.
And clearly where central banks are right now wouldn't be coping with that kind of rate of inflation. So we will have to see an adjustment to interest rates, but we don't see them going up to anything like historically high levels.
Are growth or value stocks better positioned in 2022?
Dargan: Historically, if you look at falling interest rates has been good for the growth sector and that's really because the discounting effect of money in the future is set by the level of interest rates and growth companies tend to have more in the future and so they're more affected by lower rates. So lower rates more increase in the value of these kind of growth companies and equally value companies tend to do better. So, why is that? Well, if you are... What are value companies? It tends to be things like banks. So higher interest rates are good for banks, because they can pass on a spread more easily, the difference between what they lend at and what they borrow out, so that's good for them. It's also good for oil companies, miners, sort of the value cohort.
So, yes. That's short term, that is what we're seeing and I think that's already been reflected to a large extent in the market rotation that we've seen over the last six months plus. But if we go a little bit further forward and we say, well, what sort of companies actually do well in a slightly higher inflationary environment? It is companies that can pass on their costs and companies that can continue to grow.
If we think about the sort of companies that we own in our portfolio, they tend to be long term, innovative companies that can compound their growth because they've got an open-ended growth opportunity and they are great businesses.
Those sort of companies can pass on price and they continue to compound their earnings and grow reliably, annually each year. So over the long haul, they tend to do extremely well.
Whereas, if you think about things like banks and oil companies, energy companies, miners, for instance, they tend to do quite well short term, but they can't deliver on the same sort of rates of growth longer term. That's the sort of companies that we would typically own. So you were to look at this and we are long term investors, so if you look at this sort of five years down the road, plus, you would see that typically the sort of companies we own will have outperformed because they've been delivering on this kind of reliable growth. Whereas, these other companies that I mentioned at value cohort, require a lot of capital to go into their business for them to grow. Whereas, our sort of company don't require that kind of capital infusion and so it's very difficult for them to, for the value cohort, to deliver anything like the sort of rates of growth that our companies do and over time that gets reflected in the stock market.
Barry and the Intermede team apply laser-like focus to just one thing – high quality global companies that they expect to consistently deliver double digit percentage earnings growth, year in, year out. Hit the follow button on his profile to be the first to read his Livewire content.
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