Walking the tight rope of inflation

Volatility is likely to be the dominant feature of 2022 as central banks raise rates to curb inflation.

And as we exit earnings season, with many economies facing inflationary pressures, investors are seeking opportunities to invest in companies with an ability to protect their margins and earnings.

With headline inflation jumping to 3.5% and underlying inflation to 2.6% in the year to December 31, all eyes are on Reserve Bank of Australia (RBA) governor Phillip Lowe lifting interest rates by the end of the year. While over in Europe, UK inflation has hit a 30-year high of 5.5% with economists expecting consumer price index (CPI) to hit almost 8% in April.

So how are fund managers employing their investment processes to navigate this difficult time?

THE INFLATION TRAPPINGS

Schroders portfolio manager, Ray David, said inflation is the enemy of profit margins and bond yields which play a critical role in valuing a company.

“Persistent inflation will cause a recalibration of bond yields (long-term interest rates), which are used to value the cash flows of companies,” David said.

“Therefore, if discount rates increase further than investors’ expectations, the companies that are valued on low discount rates (or trade on high price to earnings ratios), are susceptible to significant falls in valuation.”

David said it was common these days for high-growth companies to trade on 45 times or 55 times price to earnings.

“These stocks will be susceptible to significant falls in market valuations if interest rates rise faster than expectations, a film that played out in the 1980s with the collapse of the Nifty 50,” he said.

Gaston Amoros and Alex Shevelev, senior analysts for Forager Funds Management’s Australian Shares fund, said investors may fall victim of buying stocks just because they look cheap.

An optically low price/earnings ratio can lure investors into a false sense of safety, according to Amoros and Shevelev, only for it to unravel when revenues become softer than expected and costs become higher.

“In a large and diversified business with high margins, inflation may cause a minor hiccup. In a lower quality, lower margin business this can lead to a catastrophic “crunching” of margins and ensuing reduction in earnings,” Shevelev said.“Cheap can turn expensive very quickly.”

Antares head of fundamentals, John Guadagnuolo, said a lack of due diligence on the operational side of a business could lead to the investor underestimating the impact of rising costs on margins.

“Further, unless a revenue model is properly understood, the assumption often made about passing such costs on can be greatly overestimated.”

CHANNEL CHECKS

Michelle Lopez, head of Australian equities at abrdn, says it is important that investors undertake checks of suppliers and industry associated with the stocks they invest in.

“We frequently undertake channel checks with various players within a company’s value chain from suppliers through to customers,” said Lopez.

“We do this internally, leveraging our global network of over 120 equity analysts located on the ground across most continents, as well as externally, through third party expert networks.”

Amoros and Shevelev from Forager said they often had conversations with industry consultants, competitors, suppliers, and customers of the businesses they invested in or the ones they were contemplating investing in.

“From these we try to fine tune our views of both near-term effects from higher costs as well as the ability of the businesses to pass those costs along to customers in the medium term,” said Amoros.

Guadagnuolo said he speaks to numerous participants, especially in the transportation and logistics spaces around pressures from fuel, absenteeism related to COVID isolation rules, as well as freight rates.

“In retail, we speak to numerous suppliers to gauge the level of price inflation coming through the supply chains and to put our transport research into perspective. Another growing area of concern has been around cost inflation in mining as border closures and COVID protocols continue to hinder productivity.”

MANAGING INFLATION RISK

David says his Schroders Australian Equity team regularly discuss company valuations, industry trends, and the long-term picture of profit and returns for each company.

“Part of this process involves understanding industry structure, the drivers of historical financial performance, and what are the critical issues that will shape our long-term financial forecasts and valuation going forward,” David said.

“This research process forms the basis of our knowledge of company unit economics, enabling us to determine how a company can manage in a set of industry conditions.

“With inflation now at a 20-year high, this process helps us assess which parts of the market are beneficiaries, and which are likely to be impacted.”

David says his team has been well positioned for this scenario for some time, as valuations for inflation beneficiary sectors such as materials, cyclicals, and communications have been attractive in 2021.

SG Hiscock & Co portfolio manager, Hamish Tadgell, said his fund mitigates inflation risk by looking for companies with a strong competitive advantage and pricing power.

“This is particularly important in a rising cost environment, where the ability to pass on cost becomes critical to managing margins and profitability,” Tadgell said.

“At a portfolio construction perspective, it is also important to manage duration risk and exposure to sectors more linked to underlying economic conditions. Commodities and more cyclical stocks tend to benefit from rising prices and be less susceptible to the risk of rising rates and impact on valuations.”

Tadgell said bargaining power with suppliers, the degree of supply chain integration and the ability to manage labour costs tended to have a significant bearing on a companies’ ability to deal with costs.

“How they deal with them generally comes down to pricing power and the competitiveness of the market in which they operate,” he said.

“It goes without saying, the ability of companies to pass on costs and how this effects demand for their offering and ultimately sales and margins will be a focus.

“It always is, but the attention will be even more acute given the inflationary pressures that currently exist.”

Tribeca Investment Partners’ portfolio manager, Simon Brown, said his firm relied on an overarching risk management framework that identified inflation-associated risks.

“A rigorous focus on valuations and an internal peer review process on how our team derives value is an initial checkpoint.

“Our Portfolio Construction Tool (PCT) is our main risk overlay on the portfolio, identifying the risks the portfolio is throwing up as a whole. From this point, we can mitigate or accentuate risks as we deem appropriate, including those associated with inflation.”

Brown said he looked for businesses that could increase prices easily, even if demand was flat or if there was excess capacity, without losing significant amounts of market share or volume and attractive attributes.

“These may be producers of popular or essential products, or in mono/oligopolistic industries. Also, stocks that have fixed assets with low levels of capital expenditure such as real estate should weather higher costs relatively well,” Brown said.

“Elevated inflation can act as a tax on capital and lower returns on any capital investment, so stocks with major capital investment programs will need to be scrutinised closely. High levels of variable cost, particularly labour, may also present a challenge especially given current levels of unemployment.”

Lazard Asset Management Australian equity portfolio manager, Aaron Binsted, said he was positioning his portfolio in names that were delivering strong earnings today that were attractively priced.

“We also see a great valuation opportunity in areas of the market that benefit from inflation, specifically energy, materials and some non-bank financials,” Binsted said.

“One of the key drivers of inflation globally has been higher energy prices. Energy stocks are beneficiaries of higher inflation and have historically been the strongest-performing sector during inflationary periods.

“Yet, Australian energy stocks have not kept pace with rising commodity prices or their international peers.

“We believe that Australian energy stocks are very attractively priced even on very pessimistic assumptions and there will be a catchup in Australian energy stocks. 

“There remains great demand for gas (particularly from Asia) and we believe they are a net beneficiary during the energy transition.”

BUYS AND SELLS

Guadagnuolo said it was too early to tell which companies were navigating the inflationary environment best, but channel checks by the firm had suggested distribution company Metcash was dealing with supply chain issues better than the major supermarkets and winning some market share.

“Further, as a wholesaler with a strong market position compared to its customers, Metcash has historically benefitted from rising input costs as its takes stock profits,” he said.

He said the Antares Ex-20 strategy had sold out of two companies based on inflation risk.

“The first of these was Downer which, as a services business, is highly exposed to the lack of labour supply and COVID enforced absenteeism. More recently we have exited our position in Qube Logistics, for similar reasons.  We have also sold our position in Wisetech Global,” said Guadagnuolo.

“While Wisetech Global has a very strong industry position and actually benefits from supply chain congestion, we believed its valuation was extremely challenging, even before rates started to move higher in response to growing inflationary pressures.”

Lazard’s Binsted said his fund was selectively exposed to real estate investment trusts (REITs).

“Looking forward, the prospect of higher inflation and interest rates resulting in rising cap rates has increased the downside risk to property valuations, and hence the exposure to the REIT sector was reduced,” said Binsted.

Brown said advanced cooling manufacturer PWR Holdings was navigating inflation well.

“PWR Holdings previously had the majority of their cost base in AUD, and as an exporter, the majority of revenue denominated in foreign currency. It has successfully navigated periods of higher costs, during periods of appreciating AUD, well in the past,” said Brown.

Over at Schroders, David said global packaging company Amcor stood to weather a higher cost environment.

“While packaging is generally a commoditised industry, Amcor’s global scale and cost leadership has culminated in the company having leading market shares across its substrates and geographies,” said David.

“Prior to reporting season, our industry channel checks indicated significant price rises of 10%-15% were being implemented, compared to a long-run history of consumer price index (CPI) level increases.

“Lo and behold, the first-half profit result showed a 10% revenue increase, which was all price just to offset cost pressure. Without these price rises, profits and shareholder value would have been decimated.”

He said his fund had reduced exposure to the Australian supermarket sector in the last 12 months.

“Part of the decision was also related to these companies trading on expensive valuations having been winners from the lockdowns, as well as the likelihood of declining returns from their investment in infrastructure to facilitate online services.

“The margin on online delivery is lower due to the labour cost of picking and packing individual orders.”