As we head into the summer investors’ most common concern is the outlook for inflation. The unprecedented release of pent-up demand emerging from the pandemic, alongside ongoing fiscal and monetary support, is crashing into a supply chain facing ongoing disruption. The US Consumer Price Index (CPI) hit 5% in May, the highest level since 2008, and UK inflation has also risen above the Bank of England’s 2% target.
Whether or not these conditions prove temporary (as central bankers hope) is uncertain, but identifying businesses well-placed to benefit from rising prices should be on the agenda of all investors. To find them, we have focused on backing market leaders enjoying pricing power and the ability to recover rising input costs. We have also sought out businesses that have invested well – especially where the capital required for growth has already been spent.
Printing profits
An example of a market leader poised to benefit from historic investment is Xaar (LSE: XAR), a designer and manufacturer of industrial inkjet print heads. The group enjoys world-leading intellectual property, with a competitive advantage in jetting high-viscosity fluids. After a period of commercial missteps, Xaar is now led by a new team, which has rapidly addressed the errors of the past.
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Many years of expensed but under-exploited research and development is being monetised, accelerating sales; this growth can be readily served by the group’s well-invested Huntingdon manufacturing facility, which can support a doubling of revenue with minimum further spending. Despite a strong run, the shares currently trade on an enterprise value-to-sales (EV/sales) ratio of around two, which feels too low for a well-invested technology leader with a full new product pipeline.
Embedded value in Elementis
Another way to be well invested against inflation is to own your raw materials. Elementis (LSE: ELM) is one such fortunate firm. It is a speciality-chemicals company serving the industrial and personal-care markets, where it enjoys market-leading positions and unique products. Unusually, Elementis owns a number of mines, from which it sources significant amounts of material. In addition, it has recently completed a significant investment programme, building a new factory in India.
This, combined with ongoing investment in new product areas, should deliver a meaningful step-up in margins to support a strong recovery in revenue emerging from Covid-19. The market continues to undervalue the group’s potential.
Devro (LSE: DVO) is the leading manufacturer of collagen sausage skins, with strong market positions across Europe and the US, and growing positions in Asia and Latin America. The group went through a major capital investment programme before 2017, expanding its manufacturing footprint. The focus in recent years has been on driving efficiency from operations and ramping up the commercial effort to grow sales. With much of this heavy lifting done, Devro is well-placed to emerge from the pandemic and reap the rewards of its investment. It trades on a prospective free cash-flow yield of 7%-8% and a price/earnings ratio some 40% below its key listed peers.
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