What to look for when seeking inflation-proof investments

There are a few characteristics investors can look for when seeking out companies with durable pricing power.

Packing a punch

The packaging sector is a strong example. Global packaging companies such as Amcor and Orora provide innovative packaging solutions to clients in the healthcare, food and pet food categories. The cost of packaging is typically a relatively small component of the food or consumer product, which makes passing on the higher cost of labour or raw materials easier.

Most importantly, these companies bring value-added packaging solutions that enhance their customers’ products, such as extending the shelf life of a food product or providing the convenience of resealable pet food packaging. These value-adds help drive sales and provide these companies points of difference which shield them from competition.

The durability of pricing power, especially in the case of Amcor, is reflected in the steadiness of its profit margins and return profiles over a long period of time.

Real estate classified portals REA and Domain also show durable pricing power. These portals overtook traditional classifieds many years ago and erected significant barriers to keep out new competitors.

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Their pricing power is grounded on superior access to a strong distribution channel that is not easily substitutable. Ironically, demand for their real estate advertising services should increase, or at least hold firm, in a softer property market as vendors seek to maximise their chances of selling a property.

The lessons from packaging companies and real estate portals can be applied in reverse to identify companies without the durability of pricing power.

Banks at risk

Banks are vulnerable because housing loans are the largest contributor to their earnings. There is little to differentiate between housing loans. Broadly, a loan from the ANZ is easily substitutable with one from Commonwealth Bank. If winning a customer is grounded on a low-cost base, or pricing is the chief purchasing criteria, then a bank’s competitive position could erode and profit margins could be threatened.

Food producers, such as chicken supplier Inghams Group and fresh fruit grower Costa Group, produce commodity-like products. Staked against buyers such as supermarket groups Coles and Woolworths, where pricing is an important purchasing criteria, pricing power is quickly eroded. Both Inghams and Costa have been building scale to help fortify their margin structures, but it’s been a long game that has yet to bear fruit.

Capital-intensive sectors, such as airlines, could feel a large cash flow squeeze if prices and profit margins can’t be sustained for future investment needs. As a consequence, their competitive positions may be diminished.

Inflation, and its persistence, can affect industries and companies in many ways. Companies can mitigate the effects of inflation by simply raising prices. However, the test of their pricing power will be found in the durability of their margin structure, and if management is sufficiently astute to prepare for future capital requirements should inflation persist for longer and higher than expected.

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