-- Signs of inflation are unmistakable--and we don't think this is good news for the stock or bond market.
-- Many companies will struggle to pass along higher input prices, which means lower margins and/or substitution of alternative inputs.
-- We think "moaty" firms will weather any inflation better than companies without a competitive advantage.
Inflation has been a big theme in the headlines this year, and we're not surprised at the level of focus on this important topic. In fact, our analyst team covering the consumer discretionary and staples sectors has been highlighting inflation as a concern since last autumn, and virtually every sector is touched by this risk. While core CPI growth has been muted in the US, total CPI (including food and energy) increased at a 6% annualised rate in February (the latest data available). Even if this never translates into high core CPI growth, we don't think higher food and energy prices can be ignored, as they clearly have a meaningful impact on consumer spending.
In fact, rising energy prices are playing a significant role in global inflation. High energy prices act as a tax on production. At $100 a barrel, crude oil represents 4% of global GDP, a level that is historically associated with recessions. Higher energy prices hurt twice: First, higher fuel costs must be passed through to consumers or absorbed in profit margins; and second, consumers are forced to funnel a higher share of their pay checks toward fuel, leaving less cash available for other purchases. This crowding-out effect takes the heaviest toll on consumer discretionary purchases, and we'll likely see the impact on companies in the coming quarters.
We combed through the newsflow coming out of the 1,800 companies we cover for incremental data points on whether companies are facing higher prices and how these firms are dealing with inflation. If we wait until the impacts of higher prices show up in all the high-level data, we've probably waited too long, as it will already be incorporated into stock prices. We are seeing several signs of higher input costs impacting corporate margins, particularly among no-moat firms, with cotton prices a prime example.
Take Vera Bradley (VRA), where management expects a 30% increase in cotton costs in 2011. For a company like this, where cotton is a meaningful percentage of total costs, a cost increase to this extent could literally wipe out more than half of the firm's net income. We have seen similar cotton price issues at Carter's (CRI), among others. While price increases may be able to offset some of the impact, we don't think it will allow these firms to recoup the full impact of higher input costs--not to mention that those price increases would add to the inflation problem.
Fortunately, raising prices to pass through the higher cost of an input is not the only option at a company's disposal. We have also started to see signs of companies substituting other inputs where possible. With copper prices at or near all-time highs, manufacturers of cables and wires have started substituting aluminium in place of copper. Even the US government is studying alternative metals to use in coin-making, and with good reason: The pure metal value of a nickel today is almost $0.07! In the textiles industry, some companies have tried to use more cellulose fibre and less cotton.
Economics 101 tells us the longer the price of a commodity stays high, the more likely companies will search for ways to incorporate alternatives into their products. Some companies can benefit from these shifts, particularly manufacturers of alternative inputs. Weyerhaeuser (WY), a pulp producer, has been seeing strong demand for pulp where it can be substituted for cotton. CEO Daniel Fulton said on the firm's fourth-quarter earnings call that he believed we're at "140-year high prices for cotton." Despite the possible benefits of substitution, global demand for commodities like copper and cotton are not likely to abate anytime soon, so we still think inflation is a big risk.
So if inflation does come back in a big way, what does that mean for the market? A general rule of thumb has been that stocks do well in a more inflationary environment, while bonds are hurt by higher inflation. This is because, in theory, companies will pass on price increases to consumers, maintain stable margins, and see the absolute level of earnings increase. In the case of bonds, coupons are fixed and based on a nominal rate of return, so investors holding bonds with lower coupons will see the value of their holdings fall as inflation pushes up market yields.
While the relationship between bonds and inflation is relatively straightforward, the picture is murky on the stock side. For example, if input costs increase and companies are not able to pass along those costs to consumers, margins will decline and the absolute level of earnings may not increase. Further, as inflation increases, so does uncertainty around future inflation, which raises the risk premium investors demand for holding equities. Once investors start discounting future earnings at a higher rate, valuation multiples compress, driving stock prices lower.
This dovetails with the view we have held for several quarters that the market is fully valued--we haven't seen a ton of attractive opportunities, and this dearth of ideas persists today. Particularly as the risk of increasing inflation looms and threatens to put a damper on margins and potentially valuations, the risk/reward opportunity in stocks does not signal a screaming buy to us at this point.
The spectre of inflation is likely to hit some companies and industries harder than others, and we continue to believe "moaty" firms will be better positioned to weather inflation than companies lacking a sustainable competitive advantage.
In the event that higher inflation comes to pass, we'd rather hold wide-moat names like Procter & Gamble (PG) and Colgate-Palmolive (CL), as we think firms with wide moats will have a greater ability to pass through any input price increases they face. Both of these companies benefit from strong brands that compel consumers to pay up for their products, which gives them a little more breathing room to consider price increases. We see the same situation among transportation companies, where moaty rail firms have been able to pass through fuel price increases, but no-moat trucking competitors have not.
Despite the strong position of wide-moat firms to weather an environment of higher costs, we find that these firms are undervalued by the market on average relative to no-moat firms. While the discrepancy isn't huge at this point, our analysis shows wide moat firms are trading just below our fair value estimates on average, at 0.95x fair value, while no-moat firms are trading at 1.08x fair value.
