Three of the best stocks to beat stagflation

Inflation in Britain may have come in lower than expected last month, but the Consumer Price Index is still rising at 4.2% a year. Economic growth, meanwhile, is less than impressive. According to Graham Secker at Morgan Stanley, we are now in an era of "benign stagflation". That means investors need to put their money behind companies with the strongest "pricing power". But where do you find them?

What does stagflation mean for you?

Ordinary stagflation low GDP growth and persistently high inflation is very unpleasant. Secker's "benign stagflation" isn't a whole lot better it's "a higher rate of inflation than one would anticipate" rather than "high inflation per se", combined with "a relatively low level of growth". The reason Secker believes we may face less-than-rampant inflation boils down to commodity prices. "These have tended to be the key driver of inflation, with oil most relevant for developed markets."

Although the oil price is still high, Secker expects price pressures to "abate somewhat during the second half of the year". Robust production and a narrowing of year-on-year storage deficits will also bring down natural gas prices. Meanwhile, food analyst Bart Glenn at DA Davidson believes "commodity prices have peaked, at least for the near term". But if this sort of short-term bearishness on commodities offers some relief, there are other powerful forces at work to prevent input costs easing by much.

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Emerging-market costs are rising

The problem is that commodities are not the only driver of inflationary pressures. Emerging markets such as China kept a lid on inflation in developing markets for years by churning out cheap exports. But now workers are starting to demand better pay while other price pressures are growing too Chinese inflation is already at its highest since 2008. In the short term, this points to rising input prices for Western buyers, which means higher prices for Western consumers too. As Secker points out, there is a striking recent correlation between US inflation and rising import costs from China. Asian currencies are also rising against both the dollar and the euro, which will only make Asian goods even more expensive.

So we in the West face a double whammy as the cost of goods and services rises, but weak economic growth keeps a lid on wages. However, for investors there is some hope certain firms are much better placed to prosper than others, even in this tough environment.

The importance of pricing power

In simple terms, firms make profits when they sell goods and services for more than it costs to create them. There are two immediate problems. Firstly, rising input costs will erode profit margins (the difference between sales and costs expressed as a percentage. Secondly, margins will also be squeezed as weak demand for goods and services from struggling Western consumers keeps a lid on sales prices and volumes.

Yet even against this backdrop, companies that enjoy strong pricing power should still do well. Their ability to protect their profitability will mean they materially outperform those with weak pricing power. Indeed, over the last couple of years, stocks with strong pricing power have been consistently outperforming those with relatively weak pricing power. So what gives a company the edge here?

The five forces

There are various ways pricing power can be analysed. One of the best-known frameworks was developed by Harvard's Michael Porter. He states that a company will do well when it enjoys five key advantages over peers and rivals.

Firstly, barriers to entry: capital-intensive sectors, for example, are tricky to break into and this keeps competition down and prices up. Secondly, competitive rivalry: the fewer peers a firm has, the stronger its hand in setting prices and maintaining margins. Thirdly, substitution threat: known brands have an advantage, as consumers may not make their purchasing decision purely on the basis of price they will often pay a bit more for a tried and tested product. Fourthly, customer power how easily customers can influence prices. This is usually a function of numbers: if a company only has a few key customers, they can dictate terms more easily and weaken its pricing power. Lastly, control over suppliers: the bigger the company is relative to its suppliers, the better the deals it can strike.

The winners

So who are the top dogs? Short term, the luxury goods sector has seen its pricing power improve since the start of the year. LVMH, for example, has no difficulty passing higher input costs onto end customers. But on a p/e of 21 it isn't cheap. A better example might be from the chemicals sector: BASF (Xetra: BAS) should be able to raise prices to offset rising input costs, and its forward p/e is just 10.4.

Longer term, looking back over five previous instances of stagflation in Europe, Secker notes that "defensives tend to outperform". Consumer staples firms such as Nestl (VTX: NESN), on a p/e of 16, and Unilever (LSE: ULVR), on a p/e of 15, are capable of "ramping up prices".

This article was originally published in MoneyWeek magazine issue number 546 on 15 July 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.