How To Find The Companies Shrugging Off Inflation

How To Find The Companies Shrugging Off Inflation
Theodora Lee Joseph, CFA

over 1 year ago6 mins

  • High inflation isn’t going anywhere soon, so look for companies that have pricing power and can defend their bottom line.

  • There isn’t a single formula for pricing power, but a few things matter: industry concentration, brand presence, length of contract, revenue streams, distribution platform, and product value.

  • And if all else fails, just pick a company that can slash expenses to keep its profit margin flat.

High inflation isn’t going anywhere soon, so look for companies that have pricing power and can defend their bottom line.

There isn’t a single formula for pricing power, but a few things matter: industry concentration, brand presence, length of contract, revenue streams, distribution platform, and product value.

And if all else fails, just pick a company that can slash expenses to keep its profit margin flat.

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With inflation taking its toll on global companies, it’s more important than ever to find the ones that can defend their bottom lines. And that’s where firms with strong “pricing power” – the ability to pass costs on without losing customers – come into their own. So let’s look at the characteristics that give a company pricing power, as well as which companies stand out within each of them.

A player in a concentrated industry.

When companies want to pass on price increases, they tend to gauge what the competition is prepared to do. Now, this varies from industry to industry. But those that are more mature and “concentrated” – i.e. in which fewer companies account for more of the market share – are usually more disciplined in their pricing policies. That’s because a company in the industry doesn’t have to worry so much that its competitors will suffer persistent losses in order to gain market share. In other words, they’re more able to raise their prices without losing customers.

You can check out an industry’s concentration using this tool, which provides a good insight into how they stack up against one another. Below, for example, you can see that the biggest four companies in the household & personal care sector – Procter & Gamble, Kimberly-Clark, Colgate-Palmolive, and Estée Lauder – add up to more than 70% of market share (the blue bars on the left chart). Meanwhile, the top four in the materials sector (on the right) only make up around 30% of the industry. That gives the former much more pricing power.

Market shares of top 4 companies in HPC and Materials sectors

An impressive brand presence.

When there are too many choices, consumers tend to lean towards the familiar: brands like Coca Cola, McDonalds, and Starbucks that have international brand power and consistently quality all over the world. That means they’ve carved themselves out a reputation that ensures consumers will stick with them even if they raise their prices.

LVMH is the same, but it boasts another advantage on top: not only does it have brands associated with quality like Christian Dior and Tag Heuer, it also caters to richer customers who are less price sensitive. That means luxury brands have more pricing power than your average brand.

An online-first strategy.

It’s not enough to be able to raise prices without losing sales: it’s also important to be able to raise them quickly. This is particularly difficult for retailers, restaurant chains, and similar services, all of which have to devote time and money to changing price tags, signage, and menus to reflect the new prices. But it’s easy for companies – think L'Oréal and Shiseido – that make a large proportion of their sales online, since they can adjust prices in a matter of clicks without any extra administrative costs.

Keep in mind too that technological advancements have complicated things. Take the consumer staples sector, which has always been thought of as holding relatively strong pricing power. That’s still true, but this power has been noticeably eroded as ecommerce has made it easier for small brands to bypass traditional retailers. Which brings us neatly onto…

Direct-to-customer distribution.

The more intermediaries there are between a company’s product and its customers, the less profit it gets to keep for itself. That much is obvious from Unilever’s battle with grocery chain Tesco in the UK: the conglomerate has a strong brand and healthy market share, but its ability to raise prices is still ultimately limited by the outlet that sells its products.

A portfolio of long-term, cost-indexed contracts.

Long-term contracts are a good way to make sure a company’s profit growth and margins are stable and predictable, especially in a recessionary or inflationary environment. Even better if these contracts are aligned with cost indexes, like those that track US wages or gas prices. That way, the customer is obliged to pay more as those costs rise without having to go back to square one and renegotiate new prices.

Industrial gas companies like Air Liquide, Linde, and Air Products tend to have cost-indexed contracts with their customers that last 10-15 years, which helps guarantee them a base level of demand while making sure that any increase in costs passes straight onto their customers.

Inflation-linked revenue streams.

Payment processing companies like Visa and Mastercard have an interesting business model that benefits their pricing power in an inflationary environment.

Here’s how it works: if the price of the daily cup of coffee you buy on your bank card goes from $1 to $1.50, Visa and Mastercard stand to benefit proportionally from the price increase. That’s because they charge the financial institutions that issue Visa or Mastercard-branded cards a fee based on the nominal volume of activity. Assuming you don’t cut back on your coffee, the bulk of revenue streams of both companies should grow in line with inflation.

Perceived or real value.

We’ve already mentioned that luxury shoppers are paying as much for a brand as anything else. That means the image and the identity of that brand are more important than the basic function of the product. In other words, the real value of a luxury handbag might be that it stores a few accessories, but it provides far more in perceived value. That gives luxury companies a lot more leeway to up their prices.

Chemicals and fragrances companies are the opposite, insofar as the real value of their products is often higher than perceived value. But that gives them their own freedom to up prices as they see fit. Symrise, Givaudan, and Croda, for example, only provide small quantities of ingredients to consumer companies, but they’re arguably what makes or breaks the end product. So while they only amount to around 4% of their customers’ total cost (the perceived value), switching them would be costly and potentially brand-damaging (the real value).

Bonus: The ability to cut costs.

Companies that stay lean are historically good investments, driving strong returns relative to the money they spend. But it also means they have less fat to trim in an inflationary environment than their less efficient peers. So if all else fails and a company is struggling to pass on cost increases, you’ll want to pick one that can slash expenses to keep its profit margin flat.

You can find those companies by comparing their costs as a percentage of sales against others in the same industry. A higher cost base might reveal structural inefficiencies for a company, but it also highlights where there’s fat to trim. Just make sure the companies have lower fixed costs, so that they have more flexibility in bringing expenses down.

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