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Source: Pricing power can help companies fight inflation

Over the last 2 years, there have been multiple noises in the market around the risk of inflation hitting the global economy. This has a natural effect on the valuation in the equity markets, as this has a direct implication on the discount rate at which future cash flows of a business gets priced.

There are businesses which naturally have a higher gross margin around how the industry dynamics are structured – think consumer brands, niche pharma, R&D focussed manufacturing, semiconductors and platforms.

Media was one industry which had declining gross margins and reduced pricing power, which has made them consistently generate poor returns on capital. However, Netflix bucked the trend through the power of the platform it created. Netflix too did not get here without its fair share of concerns – In 2011, Netflix raised prices by dividing its streaming subscriptions from its DVD service. This announcement sparked an uproar that forced the company to issue an apology which caused a sell-off in its stock price.

Today, the platform is in a very different space with the company raising prices 4 times since 2014 – something very few businesses have today.

Is inflation a risk today?

There are two sides to the story of inflationary risk in the economy. Over the last few years, this has been dominated by supply-side forces (asset prices going up, supply-side disruptions causing raw materials – metals, logistics, power – prices to increase). Over longer cycles, these tend to normalize themselves to the mean and do not bring about structural risk in the economy.

The second, however, is structural in nature which comes about due to demand side of the economy picking up, predominantly coming through from wage inflation, having a direct correlation to the spending disposable income. Over the last 7 years, we are looking at the demand side inflation pick up in the economy, and there is case to be made that this will sustain.

What do investors do?

I am not yet ready to make a strong case for inflation to continue to rise significantly, but I do believe that the risks to a higher inflationary world exist today. This makes it more important for investors to focus on this as a key risk for the best part of next year, considering we are entering a period where the margin of safety in terms of valuations are low.

Equities will continue to be one of the best asset classes to own during such periods as the underlying business generates cash flows which could be reinvested for the future. However, it’s important to focus on companies which have pricing power (raise prices and pass this on to the end consumer). We covered this at length in our quarterly health check review of our portfolio where we discussed the earnings trend of our portfolio companies.

With select pockets of growth, rising inflation and other risks on the horizon, 2022 may seem a daunting environment for investors. But I’m optimistic that an active portfolio of select companies with strong pricing power will help investors navigate these risks going into the next few years.