Weren't Equities Meant To Protect Us From Inflation?

UK equity investors have double reason to feel shell-shocked. Ambushed last summer by the impact on their domestic investments of some far away problems in the US, they could at least draw comfort that the long-term case for equity investment seemed in tact.

"Don’t keep your cash in a savings account — it will just be eroded by inflation," was the received wisdom. "For inflation-beating returns, you have to invest in the stock market." Words of wisdom indeed. Until inflation accelerated, that is.

With US sub-prime now receding into the rear-view mirror, a newer threat has grabbed the headlines and sent equities into another downward dive. Inflation is the new villain, already making itself felt in the pockets of ordinary citizens as fuel and food prices surge at rates that make a mockery of official inflation figures.

So what of investment portfolios constructed in part to protect their owners from the inflationary beast? With indices in retreat, it seems that the bedrock case for equity investment — the protection it provides from rising prices — is in shreds.

Across the board, companies are reporting a squeeze in profits as input costs rise. Their earnings, in other words, are falling victim to inflation.

Add in the deterioration in sentiment that reduces the multiple of earnings investors are willing to pay, and share prices are headed down. Higher interest rate expectations have added their own twist to the garrotte.

So are investors right to leave in disgust?

Yes and no. It depends on the company.

Cadbury made the news recently, delivering a strong trading statement. Its confectionery prices, it confirmed, would keep rising to counter soaring oil and cocoa costs. It would refuse the growing demand from large retailers for discounts.

The value of throwing your weight around

That’s a nice position to be in these days. But how come Cadbury can do this where so many other companies are failing?

A glance at Cadbury’s website revealed all we need to know. Cadbury is not just any old confectionery maker. It is the world’s biggest, dominating a fragmented market where there are few big players. It has brands that are known and loved around the world. When a retailing leviathan such as Tesco carps at Cadbury’s higher prices, carping may be all it can do. The bottom line is that it either pays up for Cadbury’s brands, or it goes without. There is no competitor of Cadbury in the market place that can provide quite the same thing.

This ability to charge ever higher prices is known as pricing power and is exactly what companies need if they are to prosper in today’s inflationary environment. So how do we indentify such companies?

First stop is to gain an understanding of the industry in which the company operates. What is the company’s position within the industry? What is the competitive landscape? One sure-fire way to gain pricing power is to dominate your industry. Be the biggest and chances are you can set prices. This is not always true, and much depends on the collective strength of competitors. If your two largest competitors combined are bigger than you are, they could collude and supply the market without you.

Conversely, if the competition is highly fragmented, the largest player should be able to call the shots. That’s the case with Cadbury in the fields of confectionery and candy.

Brands are key to pricing power too; they differentiate the product from a similar generic rival and enjoy loyal demand that is less sensitive to pricing.

Cadbury has a further unique advantage that insulates it from the ravages of inflation. Candy bars can be trimmed in size to give the illusion of not rising in price. This is not something that the purveyor of a litre of milk or a kilowatt of electricity can do. Cadbury’s products are inexpensive impulse buys, far from the core of household budgets. Unlike the monthly mortgage payment, they are a discretionary purchase, and they are so small-ticket as to be almost irrelevant.

So maybe the right equities can protect investors from inflation after all. But that does not mean they will always be a rewarding investment. Cadbury shares have shed significant value over the last 12 months, but investors need to strip out company performance from share price performance. The two — in the short-term at least — are not the same.

Why have decent equities been doing badly?

At present, investors are not differentiating between good and bad long-term prospects. Many equities are being lumped together and are suffering from weaker sentiment and reduced investor liquidity. The investment tide is going out.

But we’ll keep our ear to the ground. Because we could soon be faced with a great opportunity to pick-up stocks with inflation-beating credentials. Why? Because it is a near certainty that holding cash, with its rapidly declining purchasing power, will not remain the mantra for long. Dull, but inflation-busting companies are set to become the new investment favourites as the decade draws to a close.

Ask yourself this. Will Cadbury’s customers suddenly find themselves unable to finance the purchase of a candy bar? Thins will have to get A LOT worse for that to happen...

Andrew Vaughan

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