blog

For the first time in four decades the global economy is experiencing high levels of inflation.

In January 2022, the United States Consumer Price Index increased 7.5% on an annual basis, which is sharpest increase since early 1982 (see chart below). Among other factors has led many to forecast the ultra-low interest rate settings currently in place in most countries will need to change. I will leave the debate about whether inflation is transitory or permanent to others. And focus on how inflation can change a business’s earnings and how different businesses perform under various scenarios.

I’m concentrating on the earnings of the business rather than the potential consequences to the stock price from multiple rerates and derates.

inflation chart

Source: FactSet

In order to maintain or grow profits during periods of higher inflation businesses have three choices:

1. Cut back expenses

Currently businesses are experiencing rising wage levels across many industries. Under this scenario they could freeze hiring or try to cut expenses in other areas like technology, rent, marketing etc. Most businesses don’t do this out of fear that competition will erode whatever advantages they have overtime. The only businesses we see where this can occur are extremely large businesses forcing better terms with their suppliers.

2. Raise the price of your product or service.

This is obviously the preferred option compared to option #1 however you need a product or service that the end market needs rather than wants to be able to do this effectively.

3. Don’t cut expenses or raise prices

For most businesses this would mean profits are destined to fall except for some businesses with extremely good structural growth trends. Some management teams may also do this to win market share from competitors that are raising prices in the hope that the newly won business has enough volume to offset margins tightening.

I will continue to focus on the ability of a company to Raise the prices and explain what we look for in businesses and what we try to avoid.

The Great

Products/Services that customers need

This category is referring to businesses that customers struggle to avoid using.

Examples include Microsoft Office, Amazon Web Services, Mastercard/Visa, Mobile Phones etc. These companies can raise prices in most cases because customers feel like they absolutely need them.

Oligopolistic industry structures

Industries with less participants generally are less competitive on price. Essentially this is the reason we have antitrust laws because companies in these categories can take advantage of their positions.

An example in Australia is the online property portals which are dominated by Realestate.com and Domain.

High margin businesses

The opposite of lower margin businesses. As explained above it’s the math of the equation that makes the difference. Many brands that people love to fit into this category despite some of them being in intense industries.

For example, Volkswagen, Toyota, and Ford compete aggressively on price and consumers can easily substitute the product for another in most countries. These businesses have 15-18% gross margins for the most part. While Ferrari also a car manufacturer doesn’t compete on price because it has a cult-like brand following and customers who like brag how much their Ferrari cost. Consequently, their gross margins are 50%+ and they can raise their prices without a pullback in demand. Rarely people will say I bought the Lamborghini because of its affordability compared to a Ferrari.

ferrari

Asset light businesses

These businesses are typically great to own in almost all circumstances because of their high returns on capital. However they are even better compared to capital intense businesses during periods of inflation. Owners don’t need to constantly put more dollars into the business to maintain it and/or grow it.

Examples include Mastercard/Visa, Credit rating/exchange businesses like Moody’s and the ASX.

The Ugly

Fragmented Industries

Fragmented industries have dozens of participants that compete fiercely over price. This makes it more likely that price rises from one participant won’t automatically be followed by the rest of the participants leaving them at a disadvantage.

Examples of industries include clothes retailing and car manufacturers.

retailer

Contractors

These are typically some of the worst businesses to own in times of inflation. The reason being, contracts are typically well bid meaning margins are tight to begin with and they are bid on well before anyone knows the prevailing Macro environment. This means a contractor can be forced to pay much more for materials and wages than they initially thought. Long-term contracts are almost always worse in this scenario while shorter term contracts aren’t great, they can be renegotiated after the contract ends. While some contracts allow costs to be passed on to the end customer this can be challenging to do particularly if you’re expecting to bid on upcoming tenders from the same customer.

Two recent examples of contracting businesses going wrong are RCR in Australia and Carillion in the UK.

Businesses with capital requirements

Asset-heavy businesses with low returns on capital require greater investments to be made to maintain their business as inflation rises. On top of this the cost of expanding the business rises as well and projects begin to fall below satisfactory returns on capital. This includes businesses with large working capital requirements as well.

Examples include some Industrial and Telecom businesses.

Businesses with Low Gross Margins

Lower margin businesses are generally lower quality as they can’t charge a premium for their services. They are also low margin because they are beholden to large customers or stiff competition. I would also include products/services with limited brand love and plenty of substitutes that can be easily switched. There is a math element to this one as well: for insistence assuming flat volume if my costs rise is 4% and I have 50% margins than I need to put through a 2% price rise to maintain profits at the same level. While a business with 10% margins that experiences the same 4% cost increase must put through a 3.6% price increase. As inflation rises above this theoretical 4% level the challenges become far greater.

Examples include Car manufacturers, Airlines, Contractors, and Supermarkets.

My personal favourite is….

realestate.com

Realestate.com

Australian starts their search for homes, either occupier, investment, or rental, online as the old classifieds section of the newspaper has been digitalised. This online real estate market is dominated by two players, Realestate.com and Domain with Realestate.com taking around 75% of the revenue pool. In July 2021, Realestate.com raised prices by 8% for sales and 6% for rentals. In July 2019, they raised prices as well (missed 2020 due to Covid-19 downturn). This demonstrates the value they bring to the equation and the fact that it is a lot easier to sell/rent a house after advertising on Realestate.com.

Written by Nick Cummings
Oracle Global Equities Portfolio Manager

blank

Unsure where to go next?
The next step is to contact an experienced financial advisor who will tailor an investment plan to cater to your individual need and investment goals.

Book a complimentary consultation today. 

We can help you plan your way to financial freedom.

Important information – Oracle Advisory Group makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.
Enquire today to see how Oracle can assist you!
Contact us
blankOur Locations