High inflation: five ways strong businesses could defy it
Archived article: please remember tax and investment rules and circumstances can change over time. This article reflects our views at the time of publication.
UK inflation has hit a 40-year high of 9.4%. It’s a similar story globally.
How long it remains elevated is anyone’s guess. But if high inflation does hang around, the impact on businesses will be severe.
Rising costs can easily eat into companies’ profit margins. Meanwhile, businesses and consumers tighten their belts in an inflationary environment, reducing demand for goods and services.
Very few companies are immune. But which might be more likely to emerge from a possibly protracted period of high inflation unscathed? There are, in my view, five key features that could help make a business more resilient.
Selling ‘must-have’ goods or services
In an economic downturn, businesses providing ‘must have’ rather than ‘nice to have’ goods or services are usually better placed. And the harder it is for a company’s customers to stop buying its products, the better.
Take Rentokil, the pest control specialist.
Rats need dealing with, no matter what’s happening to inflation or the economy. Moreover, a large portion of Rentokil’s revenue comes from long-term contracts of one to three years. Even if a customer in the catering sector wanted to risk the Food Standards Agency’s wrath and stop paying for pest control, it couldn’t, at least not until the contract expired. This makes Rentokil’s business highly resilient, as became clear during the Covid-19 pandemic, when some of its customers’ premises were closed.
Rentokil Pest Control ongoing revenue
In an inflationary environment, the ability to raise prices without seeing demand fall is paramount. This allows a business to pass on higher costs to customers and protect profit margins.
Three factors give a business pricing power, in my view. The product or service must have at least one (preferably more) of the below:
- It must be critical
- It must be low cost
- It must be difficult or impossible to get elsewhere
Alternatively, its brand must be so strong the above three factors become irrelevant.
Consider the speciality chemicals company, Croda.
Croda’s chemicals are used in drug delivery systems. They represent a tiny fraction of the cost of developing a new drug but are critical in ensuring medicines are delivered safely.
Croda also supplies beauty companies with chemicals that confer specific properties to their products. Without these chemicals, which are often patent protected, its customers wouldn’t be able to make claims, such as ‘softer skin’.
The essential, but often inexpensive, nature of its products allows Croda to pass on higher costs quickly and easily without demand suffering. In 2021, for example, Croda saw raw material costs rise by 17%, which it was able to offset fully while growing margins.
A strong brand is another great inflation defence.
Few people notice what they pay for a can of Coca-Cola, and I think even fewer would consider grabbing an own-brand cola for the sake of saving a few pence. Luxury goods manufacturers like LVMH are in a similar position. There is tremendous status and prestige associated with a Louis Vuitton bag, which is only enhanced by a high price tag. There is also a rarity factor associated with many luxury goods, making it much easier to increase prices.
Companies with high profit margins should be less impacted by rising costs, because those costs make up a lower proportion of their revenue in the first place.
Consider retailers Next and ASOS. Next earns operating margins of about 20%, versus around 5% for ASOS. The chart below shows how a 5% increase in costs could affect their profit, assuming no change in revenue:
Impact of 5% cost increase on Next and ASOS profit (assuming no revenue change)
Next’s profit could fall by a fifth in this scenario. ASOS, due to its lower margins, could fare far worse, with its profit almost being wiped out.
Next’s higher profit margins are by design, not accidental. For example, it encourages customers to pick up orders from store by charging delivery fees, which helps keep costs down. It has also invested for many years in warehousing, automation and logistics, creating a highly efficient and profitable online business. Perhaps most importantly, in my view, it has a culture prioritising profit margins over revenue growth.
Low capital intensity
The ideal business, especially in an inflationary environment, is one that can grow revenues without tying up much more capital.
Take Google’s search engine business. The cost of selling an extra online advertising slot is minimal relative to the additional revenue it can generate. Or Microsoft selling an extra Microsoft Office licence – once the software has been created, it can be sold many times over.
Auto Trader is another very capital-light business. The group earns most of its revenue from dealers listing cars on its site. Since 2014, revenue has increased by 82% while employee numbers have fallen from 979 to 960. Capital expenditure in 2022 was just £2.8 million, compared to net cash from operations of £271.9 million. I believe all this is possible because of Auto Trader’s highly scalable, digital business model. Compare this to Auto Trader’s customers, the car dealerships. The more cars they wish to sell, the more cars they must buy. It’s a much less scalable business.
Airlines are arguably in a worse predicament. It’s expensive to keep planes in the air, especially with fuel prices soaring. If they want to expand, they need more planes and yet more staff, which is even more costly in an inflationary environment.
Economies of scale
Some companies become more efficient as they grow, providing scope to offset inflationary pressures, at least in part.
Take contract caterer, Compass Group.
Compass has low margins and is very exposed to food and labour costs, making it potentially vulnerable to high inflation. However, the company’s scale means it’s able to manage costs by investing in a range of efficiency initiatives, including digital innovations and labour scheduling tools. Smaller competitors often don’t have deep enough pockets to make similar investments. In addition, as Compass acquires more customers, it can use its greater size to demand lower prices from its suppliers and extract volume-based rebates. This has enabled the group to reduce its food and material costs as a proportion of revenue, considerably over the last decade or so.
Compass’s food/material costs (as a % of revenue)
Rentokil also benefits from economies of scale. The more customers it serves in a specific locality, the more efficient it becomes, since technicians are spending less time on the road between customer visits. This provides scope to maintain or grow margins (even if fuel and labour costs are rising), as long as new customers are being signed up. Rentokil can also use acquisitions to extract efficiencies, such as the recently announced merger with Terminix. This should present an opportunity for significant cost savings - through merging branches and procurement savings, for example.
Companies that lack the ability to benefit from economies of scale, or the opportunity for smart acquisitions, have fewer options to combat inflationary headwinds. UK supermarkets like Tesco and Sainsbury’s, for example, aren’t really generating much volume growth, nor do they have much opportunity to consolidate competitors, given their already large market shares. This could leave them more vulnerable to inflationary pressures.
Should inflation change one’s investment approach?
It hasn’t changed mine. I always hope for the best but assume the worst.
I’m always looking for resilient businesses that I think can weather economic headwinds. That means those with must-have products, pricing power, low capital intensity, scope for economies of scale and high margins. Indeed, most of the companies on my watchlist possess all five of these traits.
This doesn’t mean their shares are or will be immune to what’s going on. Many of the businesses I like have sold off quite heavily, largely because interest rates have risen in an attempt to quell inflation. This has impacted valuations for so-called ‘growth’ companies.
However, I expect the business models I favour to emerge stronger from any inflation-induced downturn – although of course only time will tell. Meanwhile, valuations are in my view looking much more palatable than they were six to 12 months ago. I intend to take full advantage of this when I launch my portfolio for Wealth Club.
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