The Lex Newsletter: soaring inflation adds urgency to search for pricing power

Dear reader,

Central bankers should take their lead from Canute, former Bank of England governor Lord Mervyn King said recently. It is no more possible to command the tide of rising prices than the waves that soaked the robes of the king.

Just now, that seems painfully obvious. Central bankers are clearly far from omnipotent. The US consumer price index is rising at its fastest annual pace since 1982.

In the UK, the BoE put the spotlight on companies that “try to maintain real profit margins”. Like workers seeking big pay rises, they risk giving domestically generated inflation its own self-sustaining momentum, Huw Pill, the central bank’s chief economist, said this week.

Investors, of course, prize the same behaviour denigrated by the rate setters. They want their companies capable of pushing up prices far enough to offset rocketing input costs.

Consumer goods companies are generally viewed as good defensive plays, so long as they make products customers really need or want to consume. But Unilever showed on Thursday how hard it was to keep up with the strongest cost inflation in decades.

The company forecasts operating margins to shrink by up to 240 basis points this year. Expect the erosion of profitability to continue, said Lex. But the shares, already trading towards the bottom of their historic range, could become a value play.

Similarly, inflation means that running UK retail group Pets at Home will be no walk in the park. Incoming chief executive Lyssa McGowan, who joins in June, will have to hope the trend for pricier, premium pet food continues. That would support operating profitability as prices rise.

Restaurant chain Chipotle Mexican Grill is faring better. Again, input costs are jumping. Lex’s own burrito inflation index suggests these rose by a tenth last year. But it has so far managed to pass costs on. It raised menu prices by 4 per cent in December and expects more increases to follow. That should sustain the appetite for the shares, which today trade on a hefty forward earnings multiple of 49 times.

Pricing power is one of the main attributes investors look for at times of high inflation. Another category of winners are commodity companies. Oil and gas producers are coining it. Energy stocks were the best performers on the S&P 500 in January. US shale producers remain a good bet if higher oil prices help deliver healthy payouts to shareholders.

Potential beneficiaries from higher interest rates also have appeal at a time of rising inflation. Investors’ heads have been turned recently by the improving prospects of relatively weak European banks. But in the medium term, France’s largest bank BNP should continue to reward the patient investor. Higher interest rates would push its return on equity up towards 12 per cent.

Property has a reputation as a good inflation hedge. That is justified in sectors well-placed to secure above-inflation rent raises. But for UK commercial real estate as a whole, the statistics tell a different story, according to analysts at Liberum. Over the long term, there is a weak negative correlation between inflation and real capital value growth.

As for domestic property, prices soared in the inflationary 1970s. But the high interest rates then needed to tame inflation brought a negative factor for asset prices. Indeed, some economists argue that the subsequent fall in rates, combined with the increase in incomes, can explain all of the rise in UK house prices since the mid-1980s.

The UK housing market hit a low point in 1996, after the recession and high interest rates of previous years. That was the year when the Ministry of Defence sold 57,400 properties to Annington Homes for £1.7bn, making it the biggest residential property owner in England and Wales.

The deal has paid off handsomely for Annington, now controlled by Terra Firma, the private equity business of Guy Hands. The government wants to unwind the deal using enfranchisement laws that enable leaseholders to buy freeholds. Opponents mutter about state expropriation. But accusations that the government is reneging on commercial pacts overstate the case, said Lex.

Regardless, the saga makes for a telling investment case study. The MoD’s “preferred business case model” assumed house price increases would never return to the long-term trend. That cost taxpayers billions of pounds. Hindsight bias is a trap, but the seller’s remorse, in this case, was fully justified.

Enjoy the weekend. Should you wish to comment on this or anything else we have written, please email [email protected]

Vanessa Houlder
Lex writer