A unique inflationary environment
As the world emerged from lockdown earlier this year, people started to enjoy themselves again leading to global demand increasing rapidly. By itself, a rise in demand normally would lead to price increases - this is known as “demand-pull” inflation. However, where this inflationary environment is different is the exacerbating circumstance of drastically limited supply. Whilst the global economy ground to a halt in 2020, governments (through the furlough scheme) and some companies, continued to pay their workforce not to be at work - people were still getting paid whilst the global economy was producing far less. Consequently, what we have seen is a surge in demand with supply drastically depleted.
In simple economic terms, raising the demand curve and lowering the supply curve drives prices higher, leading to inflation.
What can investors do about inflation?
At the moment, both cash and bonds offer an interest rate far below that of inflation. Bonds have the added problem of leaving the owner at the mercy of the market when they come to sell – in a rising interest rate environment, they may get back less should they not hold the bond to maturity. Precious metals had more relevance as a hedge against inflation when global central banks were devaluing currencies with their quantitative easing strategies. Property is also an area of interest, however the costs of upkeep rise significantly with inflation, as anyone who has attempted home renovations in the last 18 months will attest to.
It will not surprise you to hear it is our belief that equities offer the greatest protection against inflation. But not all equity investments are created equal. There is a particular combination of attributes we look for in a company that we believe gives the greatest protection from inflation and can even benefit the company.
Pricing power
Companies with superior pricing power are great to hold during inflationary periods. This means they can raise their prices in line with (or even beyond) inflation, without losing too many customers in the process.
Our favourite example is Microsoft. Earlier this year Microsoft announced they will be raising the price of their key office products by 15-20%. I imagine many of you will be reading this on your Microsoft Windows operating system, you may have received the email notifying you of this article through Microsoft Outlook, and I drafted this article in Microsoft Word. All these products are key both in your everyday and working life. If the price of Microsoft’s services goes up, you are likely to pay it.
Gross margin
But pricing power is only part of the story. When choosing our investee companies for the LF Blue Whale Growth Fund, we also pay close attention to gross margin.
We specifically look for companies with a high gross margin – this means that the uncontrollable external costs of running the business is comparatively low when compared to the revenue.
As an example, the LF Blue Whale Growth Fund has a weighted average gross margin across its investee companies of c.70%. This means that, of the companies’ total revenue, there are external costs associated with running the business of 30%. With external costs increasing due to inflation, this high gross margin is favourable over, for example, UK Blue Chip companies, which have a gross margin of c.30%, i.e. UK Blue Chips are paying the external costs of inflation on roughly 70% of their total revenues.
In short, inflation has a higher impact on businesses with a lower gross margin.
Why not have both?
It is our opinion that the “Holy Grail” of inflation-busting companies is a company that can combine a high gross margin with superior pricing power - a “double whammy” that means they are less affected by rising costs, whilst also being able to increase their prices to outpace inflation. What an investor wants to avoid, are those companies that have a low gross margin, with little or no pricing power.
At Blue Whale, our focus is on beautiful companies - companies that combine both key attributes. It is these companies that should benefit in an inflationary environment. We therefore believe inflation should be seen not as a headwind to investment performance, but potentially as a boon to the performance of those companies that can prove their mettle during inflationary times.
There is one more thing to consider - the merits of investing in great companies stand up even outside of an inflationary environment. Should this inflationary period prove to be transitory, as an investor in the LF Blue Whale Growth Fund you will still hold a portfolio of what we believe to be the most beautiful companies in the world. We hope this portfolio will outperform the wider market regardless of the macro-economic environment.
Please note that the information provided in this article is not to be construed as advice and any views we express on holdings do not constitute investment recommendations and must not be viewed as such. If you are unsure as to the suitability of an investment for your circumstances, please seek independent financial advice. Investments can go down in value as well as up so you may get back less than you invested. Your capital is at risk. Past performance is not a guide to future performance.
