Inflation at 10.7%1 is focusing investors on how to protect their investment portfolio. Consensus among Alliance Trust stock pickers is that it’s all about the company pricing power of the underlying stocks within your portfolio.
Bill Kanko, founder and president of Black Creek Investment Management says: “Over the long-term, investing in equities is a reasonable inflation hedge as revenue, cash flows and earnings adjust to the environment of higher input costs. Over shorter periods, this is not necessarily the case given rising inflation tends to be associated with declining stock prices.
“High growth stocks with little or no present earnings and cash flows are much more sensitive to the higher interest rate environment as central banks raise rates to counteract inflation. Companies that are reasonably valued and have current cash flows and earnings should be less affected by rising interest rates.
“In an inflationary environment where real bond yields are higher, investor interest will broaden out beyond the winners of the past decade (i.e., high growth companies) to other areas of the market, including ones that are more economically sensitive.
“In the short-term, stock price movements will react to the impacts of higher inflation and interest rates. However, we take a long-term approach to investing and believe that the winning businesses that we seek should fare better in this environment relative to the broad market.”
Pricing, pricing, pricing
Rajiv Jain (pictured above) chairman and chief investment officer at GQG Partners says that during inflationary periods, he attempts to optimize the construction of his portfolios in two ways.
“First, from a sector perspective, we will look to increase our exposure to names that traditionally exhibit strong pricing power, as long as those stocks continue to be reasonably valued. In addition, certain business models such as Visa Inc. have revenue that is partially driven by the dollar amount of transaction volume, which may act as an inflation hedge.
“Second, we may increase our exposure to select countries where the management teams are experienced navigating inflationary environments, particularly in India and Brazil.”
Jupiter’s head of strategy for value equities, Ben Whitmore cautions that while equities have proven a hedge against inflation over time, they react poorly to begin with to unanticipated inflation or a change from low to high levels of inflation. This can be seen in the 1970s and now to a degree.
“Real assets (commodities, property) have historically proven a good hedge against inflation. Furthermore, companies that can raise their prices in line with inflation have also proven a useful hedge. The portfolio can also be protected by the starting valuation. High inflation leads to high interest rates and this tends to favour companies where the value of the business is more determined by near term cash flows rather than businesses that are valued off cash flows a long way in the future. Low valuations tend to triumph as a result over high valuations.”
Jonathan Mills, co portfolio manager at Metropolis Capital agrees: “As part of our quality analysis, we assess whether each company in the portfolio is able to at least offset increases in input costs by raising their own prices. We believe that they are all able to do so, largely because of very strong customer loyalty and lock-in.”
George Fraisse, founder and principal at Sustainable Growth Advisers agrees that a key characteristic he looks for in companies is strong pricing power.
“We want companies that sell products or services that will allow them to protect their profit margins over the long-term,” he says. “Accordingly, our companies should be able to maintain their predictable and sustainable growth better over periods of higher inflation. We avoid commodity oriented companies which are reliant upon more cyclical demand to support the pricing of their products.”
CT Fitzpatrick, founder and chief investment officer of Vulcan Value Partners says: “Companies that have pricing power can often pass through higher costs to their customers, creating some inflation protection for their shareholders. In addition, companies with pricing power may pull forward free cash flow, reducing equity duration, and offsetting the negative effects of higher interest rates, which typically accompany higher inflation.”
Stock selection is key he adds saying that most businesses don’t have pricing power. For those that do: “While rising inflation can have a near-term negative impact on stock price performance those companies with pricing power should not see a negative impact to estimates of intrinsic value.”
An example of a company with pricing power which Vulcan holds is Aerospace manufacture, TransDigm Group.
Other features to look for
Sunil H Thakor, research analyst and co-portfolio manager of the Sands Capital Global Leaders and International Growth strategies highlights the sort of businesses that are largely immune or can even benefit from rising inflation.
“Many businesses that meet our criteria are asset-light—built on intangible, rather than tangible assets—and have limited sensitivity to global supply chain disruptions and fluctuating raw materials prices. We seek to own businesses with strong balance sheets and low debt, resulting in muted interest expenses.
“We also seek to own businesses that have market-leading positions, delivering must-have products and services. This often results in pricing power. The best pricing power, in our view, is ad valorem, where businesses capture a transaction fee; this results in a higher fee—and more revenue—as prices rise. Typically, these companies have costs that aren’t directly linked to revenue generation, so an inflationary environment is actually margin accretive.”
Stephanie Spicer is head of content at Quill PR