By now, there is unanimous consensus that inflation is happening and that it is not as transitory as once thought. I normally don’t spend time thinking about macroeconomic issues such as future inflation since it is difficult to not only forecast such factors accurately, but even more importantly, have a correct non-consensus macro view that adds value. This is why our investment strategy focuses on company-specific factors such as business quality and capital allocation and why we often say, “We own individual companies, not the market”.
On the other hand, there is a difference between acknowledging our limitations in macro forecasting and willfully and blindly ignoring the present realities in the world. Given the current environment and headlines around high inflation, it is worth thinking about how our portfolio is positioned for higher inflation.
To start, I think there are signs that inflation could cool in the not-so-distant future:
- The reopening of COVID lockdowns is leading to higher demand for “services” such as travel, concerts, and professional sports, rather than “goods” which should reduce pressure on global supply chains and logistics capacity. There are already signs that trucking rates are cooling.
- A resolution of the Ukraine/Russia conflict will cause commodity prices, especially oil, to ease from record levels.
- The labour market is easing with wage gains slowing, and people including retirees are returning to the labor force.
- Last, interest rates are going up! The Federal Reserve and the Bank of Canada have committed verbally to do what it takes to combat inflation.
Nonetheless, there are still going to be scenarios where inflation stays stubbornly high, and investors should be positioned to protect against such scenarios.
Conventional wisdom suggests that the best protection against high inflation is to own commodities and physical real estate. This has obviously been a winning trade especially for investors who purchased commodities in 2021 but rotating now at record-highs would be akin to buying “COVID-winners” in late 2020. Commodities have already rallied significantly, partly because of a supply disruption in the Ukraine/Russian conflict which should end at some point. Owning commodities has become such a consensus trade for inflation protection such that a commodities investor will only make money today if inflation continues to soar even beyond consensus expectations.
Putting aside the implications of equity valuations in an inflationary environment (the evidence is mixed), in a period of rising inflation, the best companies to own are those that have the ability to raise prices or grow revenues at least at the rate of inflation without a corresponding increase in their cost structure. These businesses will actually expand margins during this time. We own Visa, which is a good example of this since Visa simply takes a small cut of the gross activity transacted across its network and thus its revenues should at least rise with inflation.
The second bucket of companies are those with strong pricing power that should be able to protect margins. For example, Ferrari certainly has the ability to raise prices on its cars to offset higher wages and parts costs given their strong brand power and status as a luxury good.
The third bucket of companies are those that are impacted by rising costs but have a structural cost advantage over competitors and may end up gaining market share as a result. Costco is a good example of this: although it will suffer higher supply chain and labor costs, Costco’s business model has a structural cost advantage over other retailers making it easier to maintain low prices for consumers.
Finally, the fourth bucket of businesses are those that do not meet the above criteria and would therefore face lower margins and profitability in a period of high inflation. This includes:
- Companies without strong pricing power that have no structural cost advantages
- Companies with high financial leverage including debt and leases
- Unprofitable businesses that require additional funding
There are many businesses that optically appear to be high quality but nonetheless fall into the first category: PepsiCo for example is a very profitable business that will likely face compressed margins going forward due to higher supply chain and input costs, while the dispute between Loblaws and Frito-Lay (a Pepsi subsidiary) indicates challenges in raising prices. As such, margins may simply contract going forward resulting in a less profitable business.
At Baskin Wealth, our investment strategy has always focused on owning the best businesses and despite our disappointing performance in Q1, we believe our portfolio holdings fall into the first three buckets and are well positioned to maintain profitability and gain market share even in an inflationary period.