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Weathering inflation

Created:
11 April 2008
Written by:
Richard Hemming

The world's fastest production car, the Bugatti-Veryon, at £970,000 a pop is selling like hot cakes at Lamborghini London's sales yard located in the heart of Kensington. The car, which has a top speed of 252 miles per hour, is proving popular among the super wealthy in London. Lamborghini London's general manager Dominic Lancaster says that his targets are being raised after a spate of sales to City financial executives. Having already sold its quota of 30, it's now targetting 50.

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Mr Lancaster says that sales of Lamborghinis (relatively inexpensive at between £120,000 and £150,000 a car) are also booming at a time when he believed tough economic conditions would be hurting volumes.

"Sales are definitely better than expected. Enquiry rates are up 30 per cent on this time last year. We're selling to a mixture of business people, some being in the financial markets, but it's a spread of people," he says.

Back in the real world...

But while bankers, traders and other London high flying executives hurtle down the express lane, Britain's economy is slowing fast. Worse still, escalating input costs for companies due to high energy and agricultural prices are hampering profitability and limiting the impact of the traditional stimulus measure of lowering interest rates.

The Bank of England believes economic growth, which was more than 3 per cent last year, will slow to 1.6 per cent by late 2008. But, on the flip side, with oil at record levels, priced at over $100 a barrel and food prices having risen by almost 40 per cent in the past 12 months, due to record prices for soft commodities including wheat, inflation is rearing its head. In January consumer prices were 2.2 per cent higher than a year ago, above the government's 2.0 per cent inflation target. The Bank estimates that inflation will reach 3 per cent by the third quarter of this year. If it reaches 3.1 per cent, its governor Mervyn King, will have to write publicly again (he did so last April) to the Chancellor of the Exchequer.

Lombard Street Research economist, Jamie Dannhauser says that the high profile rises in food and petrol prices that will probably result in a second letter could in turn lead to raising the general public's expectations of inflation. If this happens wage demands could rise, hampering companies' profitability, which just happens to be at record high levels.

"It's a highly corrosive environment for companies. When you see input prices going up, margins get squeezed," says Mr Dannhouser.

For many companies the traditional mechanisms of maintaining margins - raising the price of its goods and services or reducing labour costs - are not an option. With a weakening economy it is difficult to raise prices and UK real labour incomes have been weak for the past two years, according to Mr Dannhauser.

Inflation, wages and profits

In contrast to wages, corporate profitability is at record levels. The net rate of return (net profit divided by the capital invested) was 16 per cent in the third quarter of 2007, according to a National Statistics release in January. This was its highest level since the Office for National Statistics started compiling data on the subject in 1965.

"In an ideal world when big shocks occur in firms' input costs, that slack would be taken up by profit margins, rather than a squeeze on labour incomes," says Mr Dannhouser.

There is little doubt that sustained rising prices and uncetainty over costs are bad for shares.

Inflation also diminishes the value of money, which has a negative on financial assets. When prices are rising, investors tend to demand higher levels of compensation from those holding their money. This means interest rates rise and so does the return required by investors in the stock market. The result: share prices fall across the board.

Although the FTSE All Share Index has fallen more than 12 per cent in the past four months, veteran fund manager Tony Nutt of Jupiter Asset Management says that the market hasn't fully factored rising inflation.

"As we speak, it's not something the equity market is taking a great deal of notice of, possibly because it's not traditional demand pull inflation, seen in Britain in the 1980s. Rather there is a significant cost push from higher energy and agricultural prices."

There is no doubt these inflationary expectations are factored in to the pricing of debt instruments. In US Treasuries the gap between the short and the long end of the yield curve for US Treasuries is at its widest for 30 years.

What to avoid

Companies to avoid in this climate are banks, whose profitability is eroded by one result of inflation: higher interest rates. In fact, all companies whose profits rely upon financial engineering will struggle because of the higher cost of money. An exception could be insurers whose services are in demand due to ageing demographics.

Other companies to avoid are those companies that will struggle to pass on higher input costs to customers. These include many manufacturers and retailers. Companies that rely on the individual consumer will struggle. These include those reliant on a buoyant housing market such as Kingfisher, Travis Perkins and Rightmove.

What to look for

When looking for companies that can weather the inflation storm, Nick Train, who manages the Finsbury Growth & Income Trust, says that quality of franchise is all important. A good franchise means that prices can be maintained (or even increased) and input cost rises passed on to suppliers.

"The strongest businesses perform best during periods of high inflation: companies with a unique product or service for which they can maintain real levels of pricing. The most important thing is to continue to invest in what you believe are good companies."

Hence companies that do well in times of high inflation all have strong niches and what management consultants might call "pricing power". One company Mr Train mentions is beverages producer Diageo. Its results in February indicated that the appetite (or thirst) for Guinness beer and Johnnie Walker scotch is strong even in difficult economic environments.

Companies whose products are a necessity no matter what the economic environment are also good to invest in during times of inflation. These include healthcare providers.

Other companies are those that benefit from rising prices, such as energy providers, including National Grid, which owns, operates and develops electricity and gas networks. We have also included oil and gas production giants BP and Royal Dutch Shell also fit this bill.

High energy prices and government subsidies for products used to make bio-fuels have also increased the prices of key agricultural products such as wheat and corn. Another factor thrown in to the mix has been a number of poor harvests. Consequently many agriculture and food prices are trading at record high levels.

The domestic listed food producers have all had meteoric share price rises, benefiting from the rising prices of soft commodities. But companies like Landkom International, New Britain Palm Oil, MP Evans and Anglo-Eastern Plantations all operate in a relatively young industry, however, and may not suit our portfolio which is focusing on established companies. For those reasons, we are leaving companies like this off our list.

Continuing on the resources theme, mining stocks are a traditional hedge against rising inflation. Throughout history, gold has been considered a store of wealth no matter how bad economic times get. But due to the volatility of the prices of underlying commodities, mining isn't the safe haven it once was. In the past year, among the most volatile shares have been BHP Billiton and Rio Tinto. Admittedly there has been an element of corporate activity, but this is reflective of the uncertainty surrounding the sector.

Back at the car yards, it is clear that if the economy turns south and inflation soars (an evil combination known as stagflation) even Bugatti-Veryon sales could hit the skids. There are already examples of car yards finding it tough. Brian Lotton, proprietor of Formula One Luxury Cars in Newcastle says he doesn't blame the Northern Rock collapse for the tough business conditions he is facing, but the housing slow down has hurt.

"Since the Northern Rock (disaster) people are hesitant in the north east. People aren't spending money, they're keeping their cars a little bit longer until they work out what's happening with the economy."

SEVEN INFLATION BUSTING SHARES...

IC Advantage subscribers can see our top seven picks for inflation-beating prowess here.

Or see this week's issue of Investors Chronicle, available now at your local newsagent.

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