Inflation
A lot is being said nowadays about inflation and in particular about the effect that it will have on stock prices, either on its own, or as a result of government policies intended to decrease it.
But of course, in the long term stock prices always follow earnings and so the question that we should be asking ourselves is…
What sort of companies have earnings that are resistant to inflation?
Ultimately we need to understand what inflation is in order to answer this question.
In economics, inflation refers to a general progressive increase in prices of goods and services in an economy.[1] When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money.[2][3] The opposite of inflation is deflation, a sustained decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index.[4]
In other words inflation is the general increase in prices.
If we think this through we can see that inflation will have 2 major impacts:
The cost of producing things will increase
The purchasing decisions of the consumers will change as a result of the increased prices
If we’re right about these 2 impacts then we can understand what sort of businesses are resistant to these impacts, and the answer become clear.
If the cost of producing things will increase, then companies that have low costs of production, either in fixed costs, or in non-fixed costs, will have an easier time surviving and thriving than companies that don’t have as much “slack”.
In the same way if consumer purchasing decisions become more cost conscious, then they might seek to prioritize lower costed goods, or reduce their spending on non-essential goods.
So does this mean that in an inflation situation budget and non-branded companies have an advantage?
After all, low cost goods is what they sell!
The answer is, like many things in economics and finance, a “It depends”.
While it’s true that some generic alternative to a brand-name good might end up benefiting from inflation, the fact is that such alternatives are already competing on price even in a normal environment.
These are very low margin businesses whose profitability is on the edge of a knife, and so increased competition, and increased production costs make it a dangerous business to be in during troubled times.
After all, if you’re competing on prices, but now you have to raise prices or sell at a loss, that’s not a good position to be in.
If you raise the price of a generic product such that it is comparable to a name brand product… Who would buy the generic?
What you really want to have is a high margin business, because even if you have increased costs, you can choose to keep your prices as is (gaining market share) and simple live with a less profits.
This is a built-in margin of safety:
In fact these high margins indicate that the company has some pricing power over their consumers, which means that the company itself may be able to raise prices more easily than their competitors with lower margins.
After all, if you think about it, a high margin product isn’t competing on price, but on the quality of the product and brand.
This means that even if the price increases, as long as the quality continues to be above and beyond the competition, consumers will continue to buy.
Capital Expenditures
The big deal in inflationary periods is Capital Expenditures because this is money that you need to pay out in order to remain in business.
These are often huge, fixed, ongoing costs that the company must spend every year just to remain competitive, and during an inflationary period the costs of these Capital Expenditures can balloon up tremendously.
A company that needs to spend 10 Billion dollars every year to keep their factories up to date is going to have a hard time doing it when inflation pops those costs up to 11 Billion.
Like Charlie Munger and Warren Buffet say:
Beware of companies that must spend money like crazy
What you really want is a company with low capital expenditures, especially one that can safely postpone majore capital expenditures to a period where it is more convenient.
Ultimately the goal here is to reduce risk by ensuring that the company has the ability to cut costs when required.
It’s this cost control ability that is extremely important in troubled times, since that, combined with stable revenues coming from established and profitable products, means that the company has a greater ability to face poor economic conditions than their competitors.
At the end of the day bankruptcy is the worst outcome to any investor, and bankruptcy is best avoided by making sure that we don’t spend more than we make, and that if what we make get reduced, so does our spending.
Of course this doesn’t mean that all companies with high Capital Expenditures are bad to own!
I’m specifically refering to the companies that must spend money just to remain in place.
If you own a gravel pit somewhere, expanding is quite difficult to do without massive capital expenditures. After all this is a business that is very local, and any expansion will necessarily require buying a second gravel pit somewhere else, which is quite pricy.
But if you pause your expansion… well your current gravel pit is going to stay right where it is, and you won’t have to spend much money maintaining it!
This type of business, where capital expenditure is required for expansion, but can be paused at any time is great for investors, since it gives us the optionality to choose when and where to invest.
Summary
In summary, my point is that during periods where inflation (or other economic troubles) are a concern, you should focus on reducing your risk by owning companies that have the following characteristics:
They have high margins during normal times
They have low capital expenditures
Do this, and you’ll have a better quality business than most, and one that will be more likely to survive the downturn and thrive during the subsequent recovery.
What about you? What do you think are the best companies to own during high inflation?
Let me know in the comments below!
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Until next time!