April 10, 2021
While the Fairlight investment process is predicated on bottom-up fundamental stock research and is not reliant on macroeconomic forecasting, one factor carefully considered by the investment team when evaluating potential investments is the risk posed by inflation. Despite a decade of record low inflation, the recent dramatic increase in the money supply via global stimulus programs has stoked investor fears that inflation is set for a return.
Inflation is generally an enemy to the equity investor; revenues and earnings appear to march relentlessly upwards, yet the investor’s real purchasing power stagnates.
Inflation, and its causes, remain a mystery to economists and central bankers with the various explanatory models and theories proposed over the years failing to provide any reliable predictive power. What can be seen from historical analysis is that equities, small caps in particular, tend to outpace inflation over the long term. Further, a portfolio of high-quality businesses with the inflation defensive characteristics of strong pricing power, high operating margins and high returns on capital will increase the probabilities an investor’s purchasing power will grow over the long term. It is Fairlight’s view that we cannot predict inflation, but we can prepare.
Do stocks hedge against inflation? A historical perspective
Whilst accepted wisdom indicates equities will do poorly in periods of high inflation, it can be seen from historical data that small caps do provide a reasonable hedge against inflation. Figure 1 illustrates the returns for large cap equities, small cap equities, corporate bonds and cash (30-day Treasury Bills) in the US from 1926 to 2000. In a normal environment, large caps, small caps and corporate bonds have broadly similar inflation-beating characteristics with returns outpacing inflation in ~70% of years. Yet when we restrict the data to just high inflationary years (>5%), it is small caps that provide investors with the greatest chance of increasing their purchasing power.
A case study – the 1970’s
This can be seen in practice during the most recent period of extended high inflation, the 1970’s. A dollar stashed away in 1970 was worth a measly 40 cents by the end of the decade. Compounding the inflationary woes for investors was the severe 1973 stock market crash, where the Dow Jones plummeted 45%. These hardly seem like fertile grounds for small cap returns. Yet, as illustrated in Figure 2, small caps were the only asset class amongst equities, bonds and cash to deliver investors an increase in their underlying purchasing power.
Characteristics of inflation resilient businesses
The Fairlight investment process is designed to identify businesses that can compound shareholder value over the long term. To qualify as an investment candidate in the Fairlight portfolio, businesses must exhibit a number of quality characteristics. However, many of these traits are shared by businesses that are also particularly inflation resistant.
The first, and most important, line of defense any business has against inflation is pricing power. The optimal business to own in an inflationary environment is one that can offset any inflation in its cost base with commensurate increases in prices without any elasticity in demand or loss in market share. Pricing power is ultimately a derivative of a business’s competitive advantages. Whilst the threat of a substitute or competitor product looms, a business is unlikely to enjoy substantial pricing power. Of the 34 investments in the Fairlight portfolio, 27 regularly increase prices.
High margins limit cost inflation downside
In an inflationary environment it is businesses with narrow operating margins that pose the greatest earnings risk. This can be illustrated with some simple arithmetic. Consider two businesses, each with $100 in revenue, one with an operating margin of 10% (costs of $90) and one with an operating margin of 30% (costs of $70). High inflation hits and each business suffers a 10% increase to its cost base without any ability to raise prices. The first business experiences a calamitous 90% decline in earnings as its margin tumbles from 10% to 1%. Meanwhile the latter business sees a more manageable 23% decline in earnings as its high starting margin provides a degree of resilience. The average operating margin of the Fairlight portfolio is 30%.
The Fairlight View
Historically equities, especially small caps with their superior growth prospects, have delivered investors increases in their purchasing power even in high inflationary environments. The Fairlight portfolio builds on those asset class tailwinds by focusing on businesses with long growth runways, demonstrable pricing power and high operating margins. Fairlight does not attempt to forecast inflation, relying instead on the quality of the portfolio to protect and grow client capital over the long term.