The following article appeared on Livewire on December 9, 2021.
As 2021 draws to a close, macroeconomic worries weigh on investors and look set to continue into 2022. The hottest topic has been inflation, which is running at a 30-year high in the US and shifted from a transitory matter to something more structural.
Our approach at Lakehouse Capital is more bottom-up-focused than it is top-down. We manage concentrated portfolios with a heavy quality-growth focus as we believe it’s the best path to compound wealth over the long term.
We focus less on macro, and more on established investing principles and economic characteristics of individual businesses that tilt probabilities in investors’ favour. In that light, how should investors react when it comes to analysing individual opportunities?
Investors could be well served to invest less time on the transitory vs permanent inflation debate, and more on tilting their portfolios to thrive regardless of the prevailing economic environment.
This thinking is anchored by the fact that not all businesses are created equal and, thankfully, investors can focus on businesses with superior economic characteristics even with inflation considerations in mind.
Traits like these speak to us across all environments but especially during a period of rising inflation:
1. Pricing power.
This is the ultimate distillation of a company’s competitive position and one of the strongest levers to combat inflation. Inflation can be a death knell for companies when they are unable to pass on rising input costs to their customers. Companies that have the ability to raise prices and keep their customers are able to comfortably navigate these inflationary periods and grow at stronger rates for longer. For example, well-known luxury brand Louis Vuitton recently increased the price of various handbags by 6%. Or consider the lesser-known CoStar Group, which provides a mission-critical data service that is widely acknowledged as the industry standard for the US commercial real estate market. Its contracts have a minimum 4.5% annual (sometimes up to 10%+) price increase built in.
2. Low-to-zero marginal costs.
The other side of the coin to pricing power is low or zero marginal costs. When it costs a company a relatively small amount to produce the product that they sell, it is reflected as high gross margins. We see a lot of this in software and platform-type companies, where the product is digital: made once, but sold many times over. To illustrate with oversimplified maths, a company that has a 90% gross margin would typically have input costs of $10 for a product it sells for $100. A company with a 30% gross margin would spend $70 to sell a product for $100. A 10% input cost increase would affect the high-margin company’s gross profit by 1% while the lower margin’s company would suffer a 23% decrease in gross profit. For this category, companies such as ServiceNow and MarketAxess are prime high gross margin examples that come to mind.
3. Toll booth business models.
Companies that have a revenue model tied to the dollar value of transactions in their ecosystem indirectly benefit from rising prices. These clip-the-ticket business models are your modern day ‘digital utilities’, such as marketplace businesses like Amazon or MercadoLibre, and global payment companies Visa or PayPal. (As a side note, we’ve recently seen share prices of payment companies pull back due to Amazon’s very public negotiation tactics with Visa, which in our view has created a potential buying opportunity.)
4. Fortress balance sheets.
Owning companies with no debt and net cash balances reduces the fundamental risk of a business, particularly during a period where interest rates may be used to chase down inflation. In the event central banks get it wrong, there’s underappreciated optionality for net cash companies to play offense while other companies are playing defence: cash is an option that never expires, and quickly becomes king during periods of the greatest opportunity.
The points above focus largely on the nearer term. It’s also useful to think through impacts of persistent inflation over the longer-term, and its potential to impact – or accelerate – structural change. Much has been written about ‘software eating the world’ and pervading every industry. Persistent cost inflation may tilt more businesses toward increasing software spend, to reduce costs and drive toward greater automation. As a reformed accountant, it has been quite stunning to watch Xero and the power of their software transform and automate part of that classical industry.
Much like expert macro opinions, there will always be businesses with opposing economic characteristics, thus creating investment winners and losers. But despite all the talk of inflation, it is not necessarily the enemy of long-term equity investors.
Active investors have the opportunity to choose the characteristics of their portfolio and tilt odds in their favour.
Seeking out high-quality businesses with superior economics, strong balance sheets and long reinvestment runways remain timeless principles to remember as we invest into 2022.
Disclosure: Donny Buchanan owns shares in Xero, and units in the Lakehouse Global Growth Fund which owns shares in Amazon, CoStar Group, LVMH, MarketAxess, MercadoLibre, PayPal, ServiceNow, and Visa.