"The single-most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business."
- Warren Buffett
An inflationary environment is viewed as negative due to its ability to turn suspected profits into losses. If an investment in a stock, bond, or savings account produces a lower return than the inflation rate, the investor loses money. Due to this possibility, years of positive returns can fade into nothing if invested in the wrong assets.
Inflation hurts the economy because it erodes the value of cash, meaning a dollar will not buy as much tomorrow as it does today. For example, in the diagram below, the $1.25 that buys a single cup of coffee in 2010, would not be enough to pay for the same cup in 2019. The price is increased to $1.59 because of the decreased value of the currency.
However, there is little need to worry in an inflationary environment if the correct assets are selected. Historically, there are some asset classes that are safer and have outperformed during times of inflation:
1. High-quality companies with pricing power
Since the dollar is worth less from the effects of inflation, prices must rise to maintain the relative worth of products and services. This means businesses may not be as profitable due to having to pay more for inputs and labor in production. The damages that this causes for a business should be worrisome for investors. Lower profitability due to rising input costs can make the difference between a company operating at a gain or a loss, negatively impacting stock price as investors see the inability of the business to make money.
High-quality businesses with the capacity, known as pricing power, to raise prices without losing volume can maintain sales and profitability during inflation. Investing in a company with pricing power helps prevent the adverse effects mentioned above that are caused by higher input costs. These investments are typically in areas where demand is highly inelastic, such as consumer staples and biotech. Inelastic demand for a good or service represents the concept that the overall quantity demanded for that product is barely affected as price changes. For example, people need to buy food and medicine, whether inflation is present or not, because they are essential products in day-to-day life.
Even with higher prices, consumers remain willing to pay for a product or service they truly need. Therefore, in an inflationary economy, pricing power is key – the consumer absorbs the higher price due to inelastic demand. When there are few alternatives to the company's product, people have no choice but to keep buying it, especially if it is an essential item in their lives. Rather than the firm enduring the negative impacts of higher costs, they leverage their pricing power to retain high levels of profitability as long as demand remains relatively equivalent to its levels before the price increase. At the same time, this ability brings both the company and its investors greater comfort and stability through rougher economic conditions.
Companies that have the most pricing power are near-monopolies. An example of this is Anheuser-Busch's ownership of multiple top-selling beer brands. They control over 40% of the world's beer profits and produce about a quarter of the beer supply. With strategic acquisitions over the past few years, Anheuser-Busch remains in an excellent place to continue this near-monopoly. Since the company controls a significant amount of production, they have pricing power. Beer, classified as a consumer staple, also has fairly inelastic demand, so consumers will continue buying Anheuser-Busch's products independent of the economic environment.
Moving to utilities, another essential service, many of the same benefits of companies with pricing power are bestowed to investors during inflationary times. Utility companies provide amenities like water, electricity, and natural gas to both residential and commercial properties. Maintaining much of the public infrastructure and providing services that people cannot live without, like heat, air conditioning, and water, utility companies see little change in demand during inflationary times.
2. Real estate or other long-contract assets with inflation protection
There is another group of assets that perform at a higher caliber throughout inflationary pressures, With contracts that allow for price increases. For example, rental properties, power plants, and gas pipelines produce very stable cash flows with built-in pricing power in their contracts with consumers. These assets have considerably high inelastic demand; Housing, energy production, and infrastructure are essential for everyday life. During periods of inflation that bring higher prices to most items, people are willing to sacrifice their discretionary spending to pay for their mandatory expenses, like a place to live.
Pertaining to real estate, investors should avoid properties that do not allow the increasing cost of inputs to be passed on to the end consumer in their contracts. Rent-controlled real estate is especially susceptible to inflationary pressures.
Another appeal of real estate is that mortgage payments are fixed, which means any increase in monthly rent is an additional profit. For example, if a 30-year mortgage requires $4,000 payments per month and the current rental rate of a property is $5,000 per month, the rental rate can be increased to $5,500 per month, leveraging pricing power. This changes monthly profit from $1,000 to $1,500, a 50% increase in rental income.
Below is a graph of equity REITs compared to the S&P 500 during the high inflation in the late 1970s and early 1980s. The dominance of real estate during inflation is illustrated in the graph; many economists draw parallels comparing the current economic environment to this inflationary period.
Data Sources: reit.com; macrotrends.net
3. Businesses purchased at a discount to their intrinsic value
The final method of navigating investments through inflationary times is buying a business for less than its intrinsic value. As opposed to the other investments discussed in the article, these businesses do not need to have significant pricing power. Sometimes the market does not realize the true value of a company, giving investors a great opportunity to capitalize on an undervalued business.
To demonstrate the power of this strategy, take a company that is, for example, worth $100 but priced at $50. Suppose we can ascertain that a company's long-term fundamentals are unchanged. In that case, the company will reach its fair value over time. In other words, within typically 2-3 years, the company will go from $50 to $100, with annualized returns being 25%. This return is multiple times higher than the current inflation rate of about 8%. It is a great way to outpace inflation.
It is essential to invest intelligently across all market conditions. However, the best way to do this is to combine the first and third strategies listed above. High-quality companies with pricing power selling at a discount to their intrinsic value is the most promising approach to navigating uncertain inflationary periods. At the same time, an investment that has both qualities would most likely prove to be an ideal asset to hold through any economic environment, including the market conditions existing today.
Siddharth Singhai
Chairman & CIO of Ironhold Capital
Disclaimer:
This White Paper expresses the views of the author as of the date indicated and such views are subject to change without notice. Ironhold Capital has no duty or obligation to update the information contained herein. Further, Ironhold makes no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
This White Paper is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Ironhold Capital Fund 1, L.P. (“Ironhold”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.
