A slowing economy plus higher inflation, represent a tougher environment for investors more used to low interest rates and steady growth. Fund managers are now talking up the “pricing power” and “inflation-proofing” characteristics of their holdings. But what traits can really shield a company from the worst ravages of inflation?
In his latest letter to investors, fund manager Terry Smith makes two key points about how owning “quality” stocks makes his portfolio more resilient against both inflation and slowing growth. Firstly, Smith looks at the impact inflation has on a company’s material costs. The average company in his portfolio has a gross margin of 60%, against his estimate of 40% for the average large listed company. These higher margins offer inflation protection – if the average cost of goods sold rises by 5%, his portfolio will see overall costs rise by two percentage points (that is, 5% of 40% (100%-60%)); the average big company will see a rise of three (5% of 60% (100%-40%)).
However, inflation in materials costs is not the sole or even the main inflationary threat to margins. For many of the stocks Smith holds, especially tech stocks such as Microsoft, Adobe and Meta Platforms, rising labour costs are likely to be a bigger driver of margin pressure, especially for the likes of Meta, whose stock options are significantly underwater, meaning it will probably either have to reprice the options or offer higher cash compensation (or both) to retain key staff.
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So while a high gross margin helps, it is not enough alone. That leads to Smith’s second point, which is that – partly, but not wholly, as a result of falling share prices – the free cash flow yield (FCFY) on his portfolio (his preferred valuation metric – see below) had risen from 2.7% at the end of 2021 to 3.6% at the end of June 2022, a valuation not seen since the end of 2017. That’s quite a swing. An FCFY of under 3% did not seem cheap, but an FCFY approaching 4% does not seem expensive, especially if rates are close to peaking. Smith’s portfolio value fell by 18% in the first half of this year, meaning the improved FCFY has been driven both by the share price drop and by improvements in cash generation.
This latter point underlines the importance of finding stocks which can keep delivering growth in tougher environments – the true measure of a quality stock. Look for stocks with pricing power whose products are necessities (or as close to it as possible). Microsoft Office and Adobe Photoshop are good examples – companies may lay off staff, but they will probably keep using this software. Unfortunately, such companies are not particularly cheap, but resilience and quality are worth paying up for.
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