The Topical Financial Risk of Inflation

There are plenty of risks that investors should think about. Most are not that important or can be avoided by not investing in certain industries and by not overpaying. While trying to predict macroeconomics is a foolish endeavor, understanding and planning for the risks associated with the national or global economy is certainly worthwhile. Check out this great thread from Ensemble Capital on the topic of predictions vs. understanding the risk of macroeconomics.

Ensemble Capital @IntrinsicInv

1/25 You can’t predict the economy, but understanding the macro context is critically important for bottom up stock pickers. Whether you like it or not your company specific outlook includes a ton of implicit macro assumptions. The current macro situation demands your attention.

March 19th 2022

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Customer Decisions with a Shrinking Wallet

The consumer may be making decisions for things on price that they previously didn’t. Look for products or services that people wouldn’t dream of not purchasing and would be okay with paying more. This favors things like consumer staples compared with discretionary items.

Rise of Production Costs

Raw material and labor costs will increase. Can the business survive if the costs rise quickly and will it be able to pass this extra cost onto customers without eroding value and impacting margins.

Some businesses are better suited. Some will have much higher margins that can absorb inflation of costs. Some are able to pass on price hikes without customers feeling they have lost value. Some businesses will offer value to the customer relative to more luxurious competition such as lower priced grocery stores and dollar stores. Some will have built in price escalation either explicitly or implicitly in the structure of their contracts.

Hard Assets

While physical assets appreciating seems like a great thing on the surface, it’s important to consider the costs associated with maintaining and replacing those assets as they depreciate. Compared with an asset light business, the asset heavy business compared at similar earnings multiples, will need to spend much more just to stay afloat. The depreciation can help offset these costs but this is done in old dollar terms whereas the replacement will be done with new dollars at higher real costs. Where this could be a net benefit is for high hard asset businesses where the asset is not depreciating very quickly. It may initially sound counter to common thinking but if you don’t believe me, before making up your mind on the matter, I would encourage you to read the example provided by Warren Buffett in the 1983 letter to Berkshire Hathaway shareholders. In the letter, he illustrates the lesson using See’s Candies.

For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses.

- Warren Buffett, 1983 Berkshire Hathaway Letter to Shareholders

Sticky Recurring Revenues

Many investors point to software and subscription type businesses as ideas for what might do well with inflation.

I think this is only good as a first layer filter. Really, there are only a few consumer facing subscription or software businesses that could continually pass on cost increases without losing customers. I believe what you really want is a business that is essential to the customers’ experience. For consumers, this could be something like Netflix, tobacco, alcohol or some other low priced staples. For businesses this could be software such as Microsoft Office, tax and financial reporting software, or most enterprise software that is critical to operations. What it isn’t includes things like the #5 competitor to Netflix, mail order food subscription services, finance newsletter subscriptions, etc.

A Few Ideas

Here’s a few ideas of businesses that will likely survive relatively well in a sustained high inflation environment. This isn’t a comment on the current valuation of the business which should also be considered before any investment decision.

• Moody’s / S&P Global - The bond ratings business has pretty good pricing power and high margins. Their businesses will be impacted by a recession but historically haves survived to become stronger afterwards

• Netflix - Pricing power exists for Netflix given its dominance in the media streaming business. Most people will continue to be okay with some price increases over time. Production costs is not insignificant and may be a consideration when evaluating this one.

• Coke/Pepsi - Even if no name cola/snacks are cheaper, customers will continue deciding to buy more Coke and Pepsi. They have pricing power and are not capital intense.

• Proctor and Gamble (and other similar) - Toothpaste and cleaning products are not getting cut from consumer budgets. Most of their products are relatively low price and they have pricing power. that can continue to pass on price increases over time.

• Visa/Mastercard - They take a tiny percentage of the transaction so if prices rise so does their take. Of course, if transactions fall they will be negatively impacted but should have no issue surviving the downturn given their solid balance sheet and high margins.

• Constellation Software - Their software products are generally aimed at being mission critical with low competition. Business customers will not typically want to rip out their products to save a few dollars as it is generally not a significant cost for their operations and such a change is disruptive. The other advantage for CSI is that public and private equity valuations dropping will provide some good acquisition opportunities.

• Tobacco companies (Altria, Philip Morris, British American) - They sell low priced and addictive products which their customers find value in. They have high margins and don’t require significant capital. Price increases will not deter customers significantly compared to the average business.

Equity investments may suffer in general due to either real or perceived impacts. These businesses may not necessarily be excluded from this market sentiment risk over the short to medium term. One way to mitigate this risk would be with some diversity in your asset allocation. I will refrain from comment on any suggestions or specific discussions in this area.

For more discussion on inflation and potential impacts to inflation, check out a recent Twitter Spaces here:

Twitter Spaces talk about inflation

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