Who’s Afraid of the Inflation Wolf?


    Over the past year, governments around the world have pumped huge amounts of emergency funds into their local economies to help counter the devastation caused by the COVID-19 pandemic. In the United States alone, the Trump and Biden administrations have trained a bazooka on the problem, spending a combined $ 2 trillion to help millions of households and small businesses.

    There is only one problem: Hardly any stimulus has found its way into the real economy. According to the US Federal Reserve, most households put it in savings – only about 25% of economic checks have been issued to date. JP Morgan reports that US households in the lowest income quartile were the only ones who actually used the grant for everyday needs. That means US banks hold record levels of cash in checking accounts. If that wall of money suddenly returns to the economy, the rate of inflation could accelerate. Bottlenecks in the supply chain and rising raw material prices do not help.

    Inflation worries investors, and many are trying to protect their portfolios by investing in cyclical stocks such as financial, industrial, and commodities, which are believed to be the best protection against inflation. However, investors should be more on the lookout for quality stocks. There are three points to consider below.

    1. Wall Street Talkingheads encourage investors to invest in cyclical stocks. In a way, it makes sense: banks lend more money at higher interest rates, and energy companies do the same when the price of oil rises. In the short term, inflation will be a tailwind for cyclical companies, and for those who believe they can time the market, we agree that so-called reflationary trading still has life in it. However, when you take a long-term perspective, real, not nominal, earnings growth is what determines equity growth.

    2. The case for investing in cyclical companies. Take banks first. Banks are a bridge between the present and the future. They make money when their customers are doing well. We agree that if the Fed decides to hike rates to fight inflation, banks could become more profitable in the short term from the spread between long and short term rates. This dynamic is not sustainable in the long term. In a higher inflation scenario, customers will struggle to pay off their debts and non-performing loans (NPLs) will increase. In addition, the banks are faced with rising operating costs in the form of higher wages and higher depreciation expenses for the expansion of their infrastructure.

    Conventional wisdom has it that banks thrive at higher interest rates, but the argument doesn’t hold up. Since banks offer standard products that show little difference between a mortgage from bank A and bank B, customers ultimately only look for the lowest interest rate. Case in point: M&T Bank is considered one of the best managed banks in the United States because it has maintained a relatively stable ROA regardless of interest rates. However, the ROE has moved up and down over time due to changes in the leverage ratio – not interest rates (Illustration 1).

    Figure 1: M&T Bank


    3. Energy companies thrive under a Goldilocks scenario, when oil demand grows gradually with global GDP and prices rise in line with affordability. As in our banking discussion above, energy companies can benefit in the short term when the price of oil rises with inflation. In the long term, these companies run in place when prices rise nominally and volume growth is subdued. Additionally, the energy industry is a capital-intensive industry and when inflation rises management can postpone maintenance investments to improve the bottom line.

    Investors should consider Royal Dutch Shell’s historical returns over the past 30 years during periods of high and low oil prices. It is difficult to get excited about a business when the allocation of capital depends on the forecast of the price of oil. In the graph below we can see that Shell tends to accelerate investments at peak times and vice versa. In the world of wealth management, the equivalent means buying at high prices and selling at low prices. The net result is inconspicuous. Over the long term, Shell had a mid-single digit return on investment, not much better than a regulated utility, but with more volatile returns (Figure 2).

    Figure 2: Royal Dutch Shell – rolling 5-year performance from 1993 to 2020


    Why quality can help protect against inflation

    As mentioned earlier, a high inflation scenario is not conducive to economic growth. Inflation transfers wealth from low-income households to those who can invest their money in inflation-linked assets.

    The same applies to corporations. In the bigger-is-better world of supply chain management, those with leverage will put pressure on their suppliers and protect themselves from inflation. The weaker ones will eat their way through their margins. Where do you want to be as an investor?

    In a high inflation scenario, investors should at least consider companies that can protect themselves. Better yet, if you can invest in companies that can thrive in times of inflation, such as those that have one or more of the following characteristics:

    1. A unique product / service that customers can rely on or who cannot switch to a cheaper version,
    2. Inflation-related income,
    3. Size and leadership to influence prices.

    Inflation or not, these are the types of business we believe investors should be focusing on. Here some examples:

    Ferrari is a premium brand open to an exclusive group of wealthy individuals, with a starting price of $ 200,000 for the Ferrari Roma, its low-end model. Customers do not typically buy a Ferrari as a means of transportation; in fact, a typical customer drives a Ferrari less than 80 miles per week. You buy a Ferrari because of its history, its driveability and its status symbol. Ferrari operates a controlled supply business model with production of less than 15,000 cars per year and a waiting list of 12-18 months. This is part of the corporate philosophy of legendary founder Enzo Ferrari, who said: «We will always sell one Ferrari less than the market wants.» Ferrari has long-term success in raising prices for new cars in the mid-single-digit range and the brand has increased the value of its cars protected from the secondary market.

    Mastercard is at the sweet spot of volume growth and pricing power in my opinion. I would have guessed, based on all of the Amazon boxes piling up in front of people’s homes for the past 18 months, that cards are finally making up most of the purchases these days. But cash is still king, accounting for more than half of global transactions, as online shopping – big and fast as it is – still lags behind real world purchases, with global e-commerce penetration in the lower teens. Additionally, companies are still in the dark about payment acceptance, relying primarily on checks and wire transfers. Cash depreciates faster when inflation is high and a high inflation scenario will further accelerate the shift from cash to cards (more likely via mobile transactions). Mastercard calculates a percentage for every transaction and the income is automatically linked to inflation. So Mastercard’s fortune rides with inflation. Better still, since it’s mostly a fixed-cost deal, inflation also boosts operating debt.

    After all, companies in emerging markets have a lot of experience in dealing with inflation. Asian Paints, for example, has been operating in India since 1942, before the country gained independence. Despite all the turmoil in India’s politics and economy over the past nearly 80 years, Asian Paints not only protected against volatility, but grew into a $ 38 billion company with sales of more than $ 3 billion. Asian Paint is the largest decorative painting company in India with a 40% market share, more than three times the size of its second competitor. Asian Paints manages an exclusive network of third party dealers, which allows it to influence prices at the retail level. Paint is a heavy product with a high water content that makes long haul transport uneconomical, which protects it from imports. In addition, Asian Paint enjoys an enormous recognition value among experts. Even in India, where labor costs are relatively cheap, paint makes up less than 30% of the total cost of a job. For professionals, quality is more important than price. It improves productivity, it gives a nice finish that minimizes repainting and increases customer satisfaction.

    Investors should not make long-term investment decisions based on short-term headlines. We understand that it is hard to compete against the crowd. Today inflation is the focus of attention, but business cycles come and go, as do alarmists. Switching tactics to inferior cyclical stocks might work for a while, but ultimately stock prices tend to follow gains, and we believe a portfolio of high quality growth stocks can increase the odds in your favor.

    David Souccar has been Portfolio Manager at Vontobel’s Quality Growth Boutique since 2016. He joined Vontobel Asset Management in April 2007 as Senior Research Analyst and was promoted to Portfolio Manager for the company’s international equity strategy in June 2016.He continues to conduct research analyzes on individual stocks that are incorporated into the company’s other strategies focusing primarily on the energy, industrial and utilities sectors.

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