Article 8 September, 2021

Real world implications of higher inflation for investors

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Much has been written in recent months about the return of inflation and whether it is ‘transitory’. The attached research paper goes into this in detail. We discuss within it how macroeconomic regime change could impact inflationary forces and, most critically, what we believe investors need to do to ‘hedge’ their portfolios against higher sustained inflation than most of us have seen in our investing life times. This is then played out by way of real-world scenarios that illustrate the impact that this could have on different types of companies. The results are not what many might think they would be. Below, we show these scenarios along with a brief summary of the thinking behind them.

Our Global Equity team's own central case is one of higher nominal growth with inflation that is higher than the recent past, but not troublesome. This should favour cyclical companies. However, in the broader equity market, we believe that due to investor positioning, the risks to this central case lie primarily in the ‘right tail’, that is higher, rather than lower, inflation. Our differentiated insight is that pricing power in such an environment would not be limited to the companies with which the average investor typically associates it today. We believe that market participants are perhaps overconfident that pricing power dynamics in a benign inflationary environment are portable into an altogether different one. This is a potentially costly short-cut assumption, considering different valuation starting points and the varying impact of rising cost of capital.

Stocks with pricing power that works with the new backdrop

The most powerful determinant of company success in an environment where we are dealing with higher inflationary forces versus the environment of the recent disinflationary past, is likely to be the value of the competitive advantage provided by a well-invested tangible capital base. We should be looking for industries where market valuations still look backwards to lower return on capital of prior cycles, but that have consolidated over the last couple of cycles, allowing greater likelihood of pricing power in the coming cycle to push through any cost inflation to customers; a well-invested capital base should allow companies to ‘harvest’ cash flow without heavy re-investment requirements.

How to judge which companies will perform well if higher inflation does take hold?

We have a lack of real-world evidence from recent decades to understand how business models might behave if higher inflation does become embedded, and thus we must accept that imperfect information and ‘first principles’ are the order of the day.  One way we can think about the issue is via worked examples. Below, we attempt to show this using four companies with varying P&L structures and what we perceive to be varying levels of pricing power. We have kept the company names anonymous as, while the exercise does use real numbers for the P&L structures, it is intended more as a theoretical experiment to explain how these behave under varying inflation scenarios, rather than as a precise forecast. The charts below highlight the different exposures to variable input costs versus more fixed costs, as well as different ongoing investment requirements over the intermediate term.

  • Company A: specialty chemicals company with contractual pass-through pricing for raw materials and a well-invested physical capital base, meaning maintenance capex is running well below depreciation.
  • Company B: vertically integrated paper & packaging company with pricing power due to a consolidated market, and a well invested physical capital base, meaning maintenance is running below depreciation.
  • Company C: leading global technology and data company, with pricing power and strong structural growth characteristics and high re-investment requirements in intangibles.
  • Company D: clothes and food retailer, with limited pricing power and relatively high reinvestment costs in both maintaining its store estate and catch-up spend on its online proposition.

“We believe that market participants are perhaps overconfident that pricing power dynamics in a benign inflationary environment are portable into an altogether different one. This is a potentially costly short-cut assumption, considering different valuation starting points and the varying impact of rising cost of capital. ”

P&L structure - view 1

Source: River and Mercantile Asset Management LLP

We can interpret the charts above as saying that Company A turns each £100 of revenue into £14 of free cash flow, while Company C, for example, produces £27 from the same £100 of revenue in a very different way. Of the four companies above, company C is today considered the highest quality – no surprise given the great margins and free cashflows – and is afforded the highest rating by the stock market. Company D is the weakest and on the lowest multiple. We can also visualise their respective P&L structure via the waterfall charts below:

Company A P&L structure

Source: River and Mercantile Asset Management LLP

Company C P&L structure

Source: River and Mercantile Asset Management LLP

The exercise we have run is to look at 2 separate scenarios to understand what the change in free cash flow could look like in each – one inflationary and one disinflationary – in order to determine how investor preference might change[1]. Scenario A sees a benign inflation environment of 2% across all cost lines, similar to that experienced over the last decade or more. Companies B and C, with their superior pricing power, are able to raise prices above inflation.  Taking into account the cost structure, company C is ultimately able to grow its free cash flow at roughly double the rate of the others. This is clearly a valuable quality and has led to strong share price performance for those companies able to demonstrate these durable growth characteristics.

However, in scenario B we assume that input cost inflation is 8% and wage cost inflation is lower at 4%, leading to overall costs rising ~5% on a blended basis. We start to see a material divergence versus scenario A – company A has contractual pass-through pricing on its raw material inputs and is able to generate operational leverage off the fixed cost base; company B has control of its raw material inputs via vertical integration and due to the pricing power afforded by a consolidated market is able to generate even stronger operational gearing by raising prices ahead of inflation; company C still has pricing power so is able to raise prices above its overall cost inflation, but due to its P&L structure it does not generate the same cash flow growth as A or B (with B now growing roughly double the rate of C); and D is unable to raise prices much more than overall wage growth due to the discretionary nature of what it sells and a lack of pricing power, meaning that its gross margins get eroded and free cash flow declines significantly.

Free cash-flow - inflationary versus disinflationary environment


Source: River and Mercantile Asset Management LLP

The lesson here is twofold: first, that the companies generating the highest earnings growth in this evironment are not the same as those doing so in a benign inflationary environment; second, that weaker companies lose out big time in this environment. In short, neither yesterday’s winners (C) or losers (D) are the best place to be. Rather, our seemingly staid packaging company turns out to be a very attractive inflation beneficiary. This is actionable from an investment perspective because the stock market currently values these businesses in a very different way to the conclusions that we draw (see chart below). In particular, it continues to look back at the winners of the last decade and still afford them a premium rating for what they achieved in that environment and the broad notion of pricing power. This valuation view looks vulnerable both in a relative sense (no longer the clear winners) and an absolute one as the duration angle discussed above comes into play.

EV/EBIT of companies A, B, C and D

Source: River and Mercantile Asset Management LLP

We posit that pricing power takes many shapes, and the optimal one in a higher cost inflation environment more likely involves vertical integration and a well-invested physical capital base, or put another way plenty of sunk cost and low re-investment requirements. We should be equally clear that even with low starting  valuation, Company D would likely be a value trap in an environment where higher cost inflation was sustained, unless input cost inflation is matched by a boom in wages.

Closing thoughts

The hugely successful Manchester United F.C. manager Sir Alex Ferguson said, “You have to make decisions with the information at your disposal, rather than what you wish you might have. I never had a problem reaching a decision based on imperfect information. That’s just the way the world works.” Such is the nature of financial markets. Some of the key allocations required in the different market regime described above might not have worked for over a decade, so investors may require a lot of convincing, or may lag their reallocations in response to evidence of sustained nominal growth and inflation. Market participants are still overcrowded in assets which demonstrated the best growth characteristics over the last cycle, but are perhaps overconfident that the pricing power dynamics in a benign inflationary environment are portable into an altogether different one. We think this is a potentially costly short-cut assumption to make that, in Ray Dalio’s terminology, could get you really hurt.

 

 

[1] Neither Scenario A nor B assumes any volume growth.

 

This document has been prepared and issued by River and Mercantile Asset Management LLP registered in England and Wales under Company No. OC317647, with its registered office at 30 Coleman Street, London EC2R 5AL.
RAMAM is authorised and regulated by the UK Financial Conduct Authority (Firm Reference Number 453087).

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