The perfect storm creating supply chain issues

Two x-factors to consider

It is often said that history doesn’t repeat but it rhymes. If this bout of inflation is more than transitory, it pays to observe what happened in the last period of sustained inflation (late 1960s to early 1980s).

While there are some similarities in the set-up (loose fiscal policy, high levels of speculative behaviour), there are some key differences.

We believe two X-factors which could impact inflation and inflation expectations are the impact of social media and the impact of the transition to green energy.

Back in the 1970s, the internet, let alone social media were not even a thought. We feel that social media has the potential to add fuel to the inflationary fire through its impact on consumer psychology.

It wasn’t that long ago that we saw ridiculous scenes around the world of people fist fighting over toilet paper in supermarkets. The speed at which user-generated information travels to hundreds of millions of the world population in a matter of seconds thanks to social media is scary.

What if these toilet paper wars were a dress rehearsal for the main event? What do we mean by this?

First of all, every time there is an empty shelf of a certain item anywhere in Australia (or the world) it will be known by the majority of the population within hours or maybe even minutes.

Consumers’ reaction to posts of empty shelves may be like the proverbial bank run. What if we start to see broad-based panic buying driven by pictures of empty shelves? Could this exacerbate the supply chain issues?

The second issue which social media could inflame is when supermarkets start putting prices up on everyday items. Wait until people start taking photos of a pack of Corn Flakes being 10% more expensive this week than the previous week.

Back in the 1970s, it may not have been as obvious and, if it was, the speed of information was materially slower. However, anecdotes of increased prices could increasingly populate people’s social media feeds.

The way that inflation can become more endemic is through the psychology of consumers and businesses alike. If consumers start believing that inflation is present, they may buy more today to save paying a higher price in the future.

Therefore, observing and understanding social media’s influence on inflation is going to be important. It is not clear whether its influence will be material, but we think it warrants our observation and analysis.

As if on cue, Jack Dorsey (CEO of Twitter) posted on the weekend: “Hyperinflation is going to change everything. It’s happening.”

It will be interesting to see how this ends.

It is commonly believed that equities offer a good inflation hedge. The argument goes that holding cash is dangerous (given that will be worth less in a year’s time from a purchasing power perspective) and given bonds will be sold off, one must hold equities.

Corporations can protect themselves from inflation by putting prices up and generating earnings growth. This theory may have been accurate in past inflationary periods, we don’t believe it is right now. Why?

• Double whammy – lower earnings and lower multiple 
  For the first time in well over a decade, we may start to see some wage inflation across the board. While wages growth in isolation is not a bad thing, we feel that it will likely put the current record corporate margins under pressure and result in downgrades to earnings.

  While some industries will just pass onto the end consumer, more competitive industries may have to wear some of the higher costs. Then there is the multiple.

  The ASX 200 All Industrials (ex-banks) FY22 P/E multiple is 28x. We feel that as interest rates increase it is inevitable that the P/E multiple will come under pressure.

  This will more than likely have a disproportionate impact on the outliers at the top P/E range 40x and above as long duration stocks (and bonds) tend to get sold off more in a rising interest rate environment.

• 40 years of deflationary pressures and decreasing interest rates 
  What has worked for the last 40 years may not work for your portfolio going forward. One needs to think laterally about which companies and industries have got a free kick from these dis-inflationary pressures.

  Almost no money managers have run money through a sustained high inflationary environment, so we are going to have to think on our feet.

  The problem is that most indexes are heavily weighted to companies which have been massive beneficiaries of the macro environment over the last 40 years. Therefore, as a whole, the index may not provide the inflation hedge people think it may offer.

• Passive investing 
  Passive investing has exacerbated this. Passive money buys whatever is in the index irrespective of its valuation.

  As a result as a company gets bigger and becomes a bigger part of the index, passive money will buy more of that company, irrespective of valuation and vice versa.

  Given the trillions of dollars which has transitioned from active to passive investment over the last decade, this has resulted in a tsunami of money buying companies just because they have gone up and selling companies just because their share prices are lower.

  As a result, companies which have had macro headwinds due to disinflation and lowering interest rates have become a smaller and smaller part of the equity indexes, irrespective of their valuation.

  The point here is that most indices are market-cap weighted and hence will have a disproportionate weighting towards those companies which have been beneficiaries of deflation.

  Therefore, passive investing will provide no protection in an inflationary environment. Having said that, we believe that certain select companies and industries will be good investments.

Back in November 2020 when the announcement of higher-than-expected vaccine efficacy was announced, there was a massive rotation away from what the market deemed growth stocks to value stocks.

At the time, a lot of cyclical companies were trading at deep discounts to mid cycle earnings and hence, as the reflation narrative took hold, they performed very strongly.

This time around is a little different. With indexes up between 30-50%, not a lot is dirt cheap. Rather than reflation from a deflationary shock, we are potentially entering a cost push inflationary environment.

For us, we don’t think one factor is going to work. Some “value” stocks will become value traps as these companies are unable to pass on their higher costs and hence their margins get crunched.

While some of the quality companies will have pricing power to be able to grow their earnings in real terms may also fall as long duration stocks de-rate as interest rates increase. We do not believe that this is going to be as simple as investing in what are perceived as value stocks.

There are going to be winners and losers in every industry in an inflationary environment, though forecasting which companies are going to be the winners is not straightforward.

Some companies with broad-based cost increases will not be able to pass these inflated costs onto their customers. We need to be very careful of investing in these businesses.

On the other side of the coin, some businesses will have pricing power to pass on higher costs but have high margins and some fixed costs. These companies will make for good investments in an inflationary environment.

Identifying this will come down to good old fashioned Porter’s analysis. Some of the areas we are focusing on are:

• Strength of customer: We are wary of anyone supplying products to oligopolies like supermarkets in Australia (Woolworths or Coles) or iron ore (BHP or RIO). While strong customers are always trying to squeeze you, trying to pass on your higher costs to customers like Coles and Woolworths is a tough conversation and has the potential to temporarily or permanently negatively impact your margins.

• Watch out for strong suppliers: Similar to the above, if you are reliant on one or two strong suppliers for essential goods or services in your business, things could get a little tricky. Take anyone advertising online having to deal with Facebook and Google in an inflationary environment. This increased cost is difficult to make up elsewhere.

• What is elasticity of good or service? What is going to be the customers reaction when you put prices up? Is the product necessary? Is there any substitute? With all prices going and real wages likely going to go down, consumers are likely going to become more discerning about value for money.

What are we looking to invest in?

A lot of the attributes listed below are traits we always look for in an investment. However, we feel that they become increasingly important in periods of bouts of inflation.

• Buy scarcity: In inflationary environments it is popular to talk about buying hard assets as an inflation protection. What does that actually mean? When people talk about hard assets, they are often referring to property. However, more important for me is to buy scarce assets. If an asset is scarce and is non-discretionary it will generally have strong pricing power which is essential in an inflationary environment. Another area, along these lines, is looking at industries where there has been very little capital invested over the last decade and will benefit from continued strong consumer demand. We like areas where there has been little to no capital investment and new capacity would take a long time to build. Areas like energy, steel, agricultural commodities and most hard commodities fall under this category.

• Sustainable cashflow and strong balance sheet: Amazon has been one of the most remarkable investments over the last decade. It had a lot of sceptics given the lack of profitability. However, Amazon has been one of the great success stories as far as value creation is concerned. That being said, there are a heap of companies which want to be the next Amazon and therefore completely disregard the merits of generating sustainable free cashflow. This does not seem to be a motivation for a large percentage of companies out there. As long as there is an element of disruption and a large total addressable market, the earnings are a secondary consideration. The flaw in this business model, however, is the assumption that debt and equity markets will always be on hand to cheaply provide capital whenever it is needed. We feel in an inflationary environment with increasing interest rates and a de-rating stock market, some of these businesses which cannot generate their own free cashflow will really start to struggle. This environment will see the old-fashioned concepts of strong balance sheets and a business model where free cashflow generation is used to sustain the business become increasingly valuable.

• Good management: One thing we have learned over the COVID period is just how important a good management team and board is when the macro environment becomes volatile and uncertain. The good management teams were decisive operationally and didn’t fall into the trap of raising equity at the lows. If we move into an inflationary environment, we need management teams to react quickly and adjust to the new macro environment. A properly incentivised management team who understands their industry, can make decisive decisions and capitalise on opportunities will be important in this environment.

• Which companies benefit from rising interest rates? In our minds, the companies which were hurt by the potential for interest rates tending to zero should, all things being equal, benefit as interest rate expectations start to increase. Clearly insurance companies and banks with large deposit bases are two types of companies which could be winners in a rising interest rate environment. The headwind from decreasing interest rates should turn into a tailwind as interest rates tick up. Clearly the Australian banks are leveraged to residential mortgages so a Goldilocks scenario is required (i.e. interest rates can go up but not too much).

• High margins, low capital intensity: A focus on business models is going to be very important. High fixed (non-CPI indexed) costs should be extremely beneficial in the first few years of inflation. However, over time, low capital-intensive businesses are good businesses to have in an inflationary environment. Eventually capital needs to be replaced and in an inflationary environment, this will eat away at returns. Business models like royalty companies, franchisors or companies which generates a lot of its excess returns through its brand name should all fare very well.

Conclusion

One of the things which we have learnt over the last 18 months is to keep an open mind and not get too confident in the prevailing macro view of the day.

We can see good evidence of lead indicators to a potentially sustained period of high inflation, however there is a lot of uncertainty. Having said that, we think it is important to consider the possibility that the investment conditions of the last four decades may change.

What has worked over the last 40 years (and exacerbated by pro-cyclical passive money in the last decade) may not work going forward. The most obvious investments which will suffer in an increasing interest rate environment are bond proxies, highly geared companies and long-duration investments.

We are not convinced that equities as a whole will offer good inflation protection, nor are we convinced a simple rotation out of growth into value will occur.

In an inflationary environment some companies are going to have their earnings and margins crunched either temporarily or more permanently.

On the long side, we are looking for companies which have pricing power, low elasticity of product, some level of scarcity, a strong balance sheet, good management, some level of fixed cost leverage or benefit from increasing interest rates.

With this in mind, we still own Woolworths and Premier Investments in retail given the high-quality management team, extremely strong balance sheets and we believe both will be beneficiaries of an inflationary environment in their space.

We own National Australia Bank and Suncorp. Again, we feel they are both well capitalised and set to benefit from increasing interest rates and like the management teams. In the commodities space we own Iluka, Oilsearch and Incitec Pivot (among others).

We like the supply side dynamics of a lot of these commodity and energy companies. Not only has there been very little capital spent over the last decade, but also there has been increased consolidation on the supply side. This makes for strong underlying commodity prices with any demand spike.

On the short side we are looking for some COVID winners, which we believe the market has valued materially too high which will fall once the economy starts to normalise.

We are short some companies which the market perceives as being structurally growing tech companies, however we believe they are much lower quality than perceived by the market.

Finally, we are looking to identify businesses which are going to experience material earnings headwinds through cost pressures and an inability to pass these on through pricing power.