Shares to beat inflation

For starters, it is important to remember that inflation really isn’t great for equities as an asset class. Data for the S&P 500, which because of its longevity is the best source for multi-decade comparisons, points to the fact that positive nominal returns on shares occur when annual inflation is in the region of 2-3 per cent. Anything above that level tends to weigh on the performance of shares. This is because, at an underlying level, companies struggle to manage inflationary pressure within their cost base – more money must be spent to maintain basic operations, which affects their ability to invest in the future.

While this is undoubtedly true for companies operating over very long timelines, there are still unexpected opportunities when it comes to shares, not least that the market tends to overreact to inflation news. With US and UK inflation each topping 9 per cent, and the latter predicted to move into double digits soon, getting a handle on the shares to offset the worst of it is a priority for investors. But paying attention to how exactly this can be done is vital if valuation traps are to be avoided. Not every bout of inflation means investors suddenly must go out and buy shares in 'inflation-proof' industries.

How we coped way back when…

At the risk of this turning into a WWWBD (‘What would Warren Buffett do?’) discussion, the sheer length of Buffett’s investing career means that his letters to shareholders contain interesting insights on investment strategies during past inflationary periods. A prime example is the Berkshire Hathaway shareholders letter from 1981. That came just after Paul Volcker announced an ultra-hawkish stance towards fighting inflation, at a time when US price growth was running at 13.5 per cent annually.

In the 1981 letter, Buffett put together a couple of useful guide points for investors thinking about how to successfully pick companies during such times that are worth quoting at length:

“Such favoured business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilised) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.  Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.”

For an investor these are important points, but they must be caveated by the fact that they are also a product of their time. The main difference between now and 1981 is that 'just-in-time' supply chains were then largely in their infancy, and developed economies were far more manufacturing and heavy industry-dependent and therefore capital intensive. Companies operated stocking systems that tended to favour local suppliers, with fluctuations in demand dealt with by having large warehouses full of product ready to ship, or components ready to go directly into the manufacturing system. Inflation in this context wasn’t necessarily a bad thing as the value of your warehouse full of product/components increased without the effort of producing a value-added product or service. With clever stock management, under such circumstances companies could create a balance sheet benefit and consequent increase in attributable net asset value through overstocking. However, the problem with this is that it directs money away from investment in the company, which has a negative long-term effect on profitability.

We can see this in the broader numbers for 1981: US businesses produced a return on equity averaging 14 per cent before tax, compared with 16 per cent for long-term taxable bonds, as coupons on the latter reflected higher interest rates that stayed ahead of underlying inflation. It also created a situation where companies had an incentive to issue debt to willing buyers, rather than equity. It is no coincidence that the red braces-wearing Masters of the Universe in the early 1980s were all bond traders.

All the same, it is open to question whether going after companies that can harness balance sheet inflation to their advantage genuinely fit into Berkshire Hathaway’s investment approach, even at the time. What Buffett was hinting at – which became his signature investment approach – is that investors should instead value the economic moats around companies that can combine powerful, trusted brands with guaranteed pricing power, more than their ability to massage their balance sheets. In this way, according to Buffett’s theory, such firms can ride out inflation while the less profitable see a relatively greater proportion of their resources being used simply to stand still.

The Weimar paradox

A surprise publishing hit in the early 2010s was a reissued work called When Money Dies by journalist and politician Adam Fergusson – who incidentally also wrote influential works on architecture. Ironically, in detailing the massive depredations of inflation during the Weimar era, Fergusson’s reissued book became a publishing sleeper hit at a point in 2011 when UK consumer price inflation reached a near-term peak in the aftermath of the financial crisis – at what now seems like a benign 5.6 per cent. The UK, for all its post-war policy missteps, never turned into Argentina. So Fergusson’s book became a sort of manual for understanding a world where prices can increase by a million per cent overnight.

One often overlooked aspect of the Weimar period is how well stock market investors did in a hyper inflationary environment. One reason for this outperformance in the Weimar Republic was companies were able to renew their capital stock via cheap loans, which were inflated away overnight, while the value of the land, buildings and machinery spiralled upwards in line with hyperinflation. The result was to artificially turbocharge a firm’s net asset value, with the further kicker that depreciation costs were typically booked almost immediately, which meant instant tax relief on prior year profits. In short, well-capitalised companies with good relations with friendly bankers were able to increase their capital asset base with borrowed money whose carrying value inflated away to nothing on a nominal basis.

As with the overstocking tactic, excess borrowing on favourable terms is not an option commonly available to companies today, although balance sheet management techniques do still have their possibilities (see below).

How do modern companies react?

But contemporary anxiety over inflation relates to the fact that comparatively few have real experience in dealing with its effects – a decent proportion of society (and even company management), is not familiar with the price growth of the early 1980s or 1990s, let alone the 1920s.

Still, there is a received wisdom for the modern business to follow. Operationally, this has to do with pushing through price hikes, and/or keeping costs under control, thereby defending net margins at all costs. Getting that formula right is nonetheless difficult as it requires companies to take a view on future inflation and organise their pricing strategies and operational response accordingly. As several industries have recently found to their cost, predicting the future is just as difficult as accurately forecasting the weather.

1) Raise prices

The ability to raise prices is one thing: the other question is how much. Car insurance companies have been caught out recently, with specialists such as Direct Line (DLG) and Sabre Insurance (SBRE) coming out with badly received trading updates that revealed basic problems with their inflation assumptions. In both cases, the companies underestimated the increases in premium prices needed to keep pace with inflation in the sector, having worked on the assumption that inflation, in this case driven by record used car prices and higher claims, would be approximately 8 per cent, whereas the real figure for the sector was 12 per cent. The resulting shortfall means that cost ratios increased, and profits will likely have to be propped up by capital releases from prior years.  

In a sense, the situation can be retrieved: insurers will be able to raise premiums as much as the market will let them. That might be slightly trickier given that they can no longer charge higher rates to existing customers, but at least the industry is driven by overwhelming need. No sane person is going to drive around without insurance.

2) Refinance debt away

Many companies used the pandemic to lock in new financing arrangements in quite unprecedented volumes. Part of this is the result of the borrowing spree of the past decade, when low interest rates made debt more attractive over the cost of issuing new equity. According to Bloomberg data, the US corporate investment grade bond market tripled in size over that time to $5tn (£4.15tn). That debt must now be refinanced and locking in funding over several years at rates between 2.55 per cent and 3.75 per cent for between five- and eight-year money has considerable attraction if the intervening rate of inflation is over 9 per cent: let inflation take the strain of reducing the corporate debt burden. In this context, looking for companies that have completed recent refinancing rounds is a good yard stick of how inflation can be harnessed to balance sheet management.

3) Margins or growth?

The latest statistics from FactSet show that the latest quarterly blended margin for all companies in the S&P 500 was 12.4 per cent, slightly below prior forecasts but still above the five-year average of 11.2 per cent. This shows us two trends that have worked in parallel. Margins reached an historic 10-year high after the pandemic as companies prioritised shareholder returns through dividends and buybacks. Research compiled by Goldman Sachs shows that share buybacks reached a multi-decade high of $900bn (£750bn) in 2021 – but in the same year research and development (R&D) spending for the US was $607bn, according to OECD figures.

Old management textbooks that deal with the inflation problem recommended that firms cut costs to defend against inflation eroding the net margin. The question is whether something like the opposite would necessarily be a bad thing. The problem with the buyback frenzy, and the debt binge that financed it, is that for shareholders it is like eating a full week's worth of meals in one day. Financing those returns has also meant freezing R&D spending in real terms; a bout of inflation will provide an incentive for companies to shift their priorities towards this area of the business, because waiting to develop products during inflationary times means spending more on the same product tomorrow.

Shares to ride out inflation

Investors should also be wary of following the inflation manual too closely when looking at specific shares. It has always been a kind of folklore in investment circles that utilities shares are a good hedge against inflation, as their status as natural monopolies should guarantee pricing power when it comes to offsetting their costs. The reality is not that simple.

Firstly, simply chasing a share without considering the price paid for it is not particularly sensible. A good utility in the US has an average price/earnings ratio north of 24. Admittedly, the UK is cheaper, with the average share for a water or electricity utility trading at around 18 times earnings.

And while the dividends are regular and yields of 4 per cent plus have an attraction, inflation can raise capital investment costs faster than these types of companies can raise their regulated prices. That’s before we even go into the politics of price caps, regulators, and windfall taxes. The high and regular stream of dividends the sector generates is not an inflation hedge, but compensation for the risk of government intervention. It is also important to remember that in the privatisation drive of the 1980s utilities firms were state-owned monopolies, so confronting a sustained bout of high inflation as private plcs is a relative novelty for these businesses.

The true measure of whether companies can stand up to inflation is to examine if price growth can positively effect their underlying business without the management needing to make an excessive effort to adapt. We look at three illustrative shares.

1) Flying with a Phoenix

While general insurers have struggled to match premium rates with rising cost inflation, this isn’t really a problem for life insurers. It is true that premiums are on a cyclical upswing, but the most important advantage for Phoenix Group (PHNX) is that rising inflation and interest rates produce a positive benefit based on the long duration of its underlying liabilities. What this means is that higher interest rates will produce better cash flow for Phoenix from its short-term cash deposits, while higher inflation erodes the value of its long-term liabilities. The key to exploiting this arbitrage is managing the risk around random variables – in this case the question of when an insurer might have to pay out on policies – but one would hope that the life insurers, at least, can measure this risk. With the PE ratio and dividend yield almost level pegging at around nine, the shares look well priced for most contingencies.

2) Keeping the spirits up

There are few shares than divide analyst (and journalist) opinion as much as premium distiller and Guinness brewer Diageo (DGE). This opinion falls broadly into two camps. The first argues that cuts to consumer spending will negatively affect its premium brands; the second camp is vehement in its view that Diageo’s market dominance in certain segments means it has uncompromising pricing power. The key point at the next results, which are due by the time this article is published, is whether the cash margin has held up under the strain of inflation. If it has, then it is a reasonable assumption that the company’s pricing power remains intact and thus has a greater margin of safety than the more commoditised soft drink manufacturers. Too much Guinness may not be good for you in the conventional sense, but it certainly takes the edge off.

3) Parents are less than Pampered

Most parents will know the benefit of a plentiful supply of nappies, a fact of which Proctor & Gamble (US:PG) is also fully aware. The maker of Pampers has a virtual stranglehold on the nappy market along with US rival Kimberly Clark and, notwithstanding the greater awareness of the environmental costs of disposable nappies, hold a 70 per cent market share between them. The cost of nappies has caused a severe controversy in the US, where prices are said to be more than twice as expensive as this time last year. While certainly a source of worry for parents with hard-pressed finances, it illustrates that a large consumer goods producer with pricing power in a market niche can successfully defend its net margin, despite pressures on input costs. By getting the rises in first, management has given itself the time and flexibility to find cost savings if these are needed. In fact, at 18 per cent, P&G’s net margin has held its own for the past three years. In a world where margins are more important than revenue growth, the latest PE ratio of 24.7 compares favourably with similarly rated utilities companies and looks to be a better hedge against inflation.

All the same, when thinking in sum investors must adjust their expectations for the next 12 months. Despite quite a lot of commentary suggesting that inflation will not be a major factor past the end of this year, expectations of rising prices are difficult to dislodge. It is very possible that further economic shocks, whether natural or man- made, keep the cycle of rising prices in place. At the very least, investors should think about what needs to change in their analysis if they are to maintain the value of their portfolios in a very different world.