“Price Rises? What Price Rises?”: How To Spot This Earnings Season’s Inflation-Proof Winners

“Price Rises? What Price Rises?”: How To Spot This Earnings Season’s Inflation-Proof Winners
Carl Hazeley

over 2 years ago3 mins

    • Commodity prices are on the rise, and that could raise companies’ input costs and dent their profitability.
    • Certain sectors have historically shown that they can manage this commodity inflation well, passing costs onto their customers and keeping profit margins intact.
    • One way to spot them is to analyze gross margins: those that rose during the last commodity boom stand a good chance of being able to do that again now.
  • Commodity prices are on the rise, and that could raise companies’ input costs and dent their profitability.
  • Certain sectors have historically shown that they can manage this commodity inflation well, passing costs onto their customers and keeping profit margins intact.
  • One way to spot them is to analyze gross margins: those that rose during the last commodity boom stand a good chance of being able to do that again now.

Mentioned in story

Energy, metal, and agriculture prices have risen at breakneck speed in 2021: if they stay where they are for the rest of this quarter, they’ll be up over 80% versus the same time last year. And since those profit-damaging prices are set to be a big talking point this earnings season, it pays to know how to spot the inflation-proof companies that’ll come out swinging.

Why are companies so worked up about commodity prices?

Commodities are important to plenty of businesses, which means their production costs climb when commodity prices – or “input costs” – do. That’s something they’ve been worrying about: just take a look at how much European companies have been mentioning “input cost inflation” recently.

European companies’ mention of “input cost inflation” by industry
European companies’ mention of “input cost inflation” by industry

Couple that with wage inflation, and companies are facing lower profits than investors might’ve been expecting. Unless, of course, they’ve planned a long way ahead or can pass some of those costs onto their customers – and that’s easier to do in some sectors than in others…

Which sectors aren’t as worried about rising costs?

There are a few more obvious candidates. Most airlines, for example, aren’t sweating the rise in oil – and, by extension, fuel – prices just yet: they typically hedge fuel costs, locking in the prices they’ll pay years in advance. Today’s high prices will eventually hit their profits, but not for a year or two.

Likewise, regulated utilities companies can pass the impact of higher energy prices straight onto customers. Renewable energy firms aren’t quite so lucky: the rising price of steel used in solar panels has more than doubled from early 2020 to record levels, and that’s a lot to expect customers to stump up for.

Source: Financial Times
Source: Financial Times

How can you spot other inflation-proof companies?

Not all companies and sectors that’ll withstand commodity-driven inflation are as obvious as the above, but there is a way to spot them: by analyzing companies’ historical gross margins.

See, a rising gross margin suggests a company has “pricing power” – that is, it’s been able to sell its products for a higher average price. So companies that were able to increase their gross margins between 2016 and 2018 – the last time major commodities and inflation ran up – should be able to repeat that trick this time around.

The first table below shows European companies that have done well on that measure, and the second, companies that haven’t. To narrow it down to companies where commodity inflation was a factor, they only include firms that directly mentioned it in their earnings calls.

Rising gross margins. Source: Bloomberg, FactSet, Thomson Reuters, Goldman Sachs
Rising gross margins. Source: Bloomberg, FactSet, Thomson Reuters, Goldman Sachs
Falling gross margins. Source: Bloomberg, FactSet, Thomson Reuters, Goldman Sachs
Falling gross margins. Source: Bloomberg, FactSet, Thomson Reuters, Goldman Sachs

So what’s the opportunity here?

These two lists are your starting points ahead of the upcoming earnings season. You’ll want to look closely at the companies with rising gross margins: try to figure out what investors are already expecting for them earnings-wise, and what’s therefore priced in. When expectations and pricing diverge, that could be a short-term opportunity to buy these stocks both now and throughout the rest of the year.

On the flip side, you’ll probably want to avoid the companies with falling gross margins. While there could be opportunities on the short and long side here, my bias is towards both quality (companies with a track record of strong fundamentals) and betting on – rather than against – companies. Going long, after all, has limitless upside, while going short has potentially limitless downside.

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