Targeting Pricing Power

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UK Inflation has jumped to a decade high, hitting 4.2% in October. These prices rises have been widely predicted by, among others, the Bank of England and the Office for Budget Responsibility. This is uncomfortable for consumers, who are facing vastly increased costs on everything from car hire (up 30%) to air fares (up 28%) to Fruit Shoots (up 32%). However, it’s also a dilemma for investors.

Most fund managers adopt one of two solutions to rising inflationary pressures: a focus on the pricing power of individual companies, or a focus on companies with ‘real’, tangible assets. While few would disagree that companies without pricing power or tangible assets look extremely vulnerable, will this approach deliver?

Companies with pricing power can pass on higher input costs to consumers, but also put pressure on suppliers. Nevertheless, judging a company’s pricing power is an inexact science. Does a strong brand really provide leverage with its suppliers? Probably, but it’s not assured. Consumer giants Nestle, Proctor & Gamble, Danone and Unilever have all said that they will raise prices before the end of the year, but the impact on sales remains unclear.

The ‘pricing power’ strategy is also looking like an increasingly crowded trade. It has become the go-to solution for fund managers responding to an inflationary environment, suggesting they could overpay. Targeting companies with pricing power is sensible in theory, but harder to enact in practice.

The other approach is to target companies with tangible assets. These managers suggest that the real risk lies not in the rising cost of goods, but in persistent wage increases. With shortages and rigidity in the labour market, wages demands of 5-6% are plausible. Goods prices can come down, but wages seldom do, leaving companies with structurally higher cost bases.

Companies where real assets make up a greater proportion of their valuation may be in a better position than ‘people’ businesses. They also tend to be more lowly rated by the market, meaning that they are not as vulnerable to a reversal in market momentum.

However, this approach also comes with risks: at a time when sustainability considerations are creating ‘stranded assets’ – those assets that are unlikely to realise their true value because of environmental concerns – investors need to ensure the assets have longevity.

Equities are almost certainly the right place to be in world of sharply rising inflation. However, it needs to be the right kind of equities and investors need to be aware that there are still risks, even with strategies based on pricing power or real assets.

 

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