Getting inflationary investments back on track


As a kid of the 1960s and 1970s, I remember my mother looking in her purse, worrying about how she might stretch household income to cope with inflation. She had an encyclopedic knowledge of supermarket prices, built on years of economics.

The worst was in 1975, when inflation peaked at 24.2 percent. For much of the past 25 years, it has hovered around 2%. For many who see double-digit increases in energy bills and at the gas pump, this new period of inflation can come as a shock.

The factors that drive it have evolved over the past six months. In the spring, prices were compared to those a year earlier, at the height of the first lockdown. It was not surprising that the prices of used cars, for example, were significantly higher. A car, used or not, was of little value during confinement.

More recently, price increases appear to have been the result of scarcity, as companies struggle to keep pace with the recovery. The stories of port blockades and driver shortages are global. Some of these blockages will probably start to go away, but others seem likely to persist.

The other important factor is wage inflation. Most of us have been happy to work for the past couple of years, so there has been little pressure for pay increases. Now is the time to catch up.

Mix it up with how Covid-19 has made many people wonder if they really need this low-paying job and all of a sudden many large employers have to raise wages significantly to attract and retain workers. Inflation, whether it comes from wages, fuels or raw materials, squeezes corporate margins, especially if it is not accompanied by booming economic conditions.

How should this affect your choice of equity holdings? Some industries, such as hospitality and entertainment, are recovering, but rising labor and energy costs are squeezing profit margins. The stock prices of many companies in these sectors have stagnated.

The reputation of other sectors for dealing with inflation may prove to be overstated. Manufacturers of popular consumer goods, for example, tend to insist that their brands are strong enough to pass inflation costs on to higher prices. Evidence suggests this is not always the case.

Take Beiersdorf, which makes Nivea cosmetics. Analysts expect its operating margin (sales minus the cost of manufacturing and selling merchandise) to drop from 15% in 2019 to around 12.8% this year, according to Bloomberg. A slight drop in operating margins can have a big impact on what shareholders have left after deducting interest and taxes – Beiersdorf’s net profit margin drops from 10 percent to around 9 percent of sales.

This partly explains why stocks have underperformed the global stock index by 25% over the past year. Unilever, which makes Dove soap, Häagen-Dazs ice cream and many other well-known consumer brands, is in a similar position.

In contrast, L’Oréal, one of our favorite holdings, seems able to pass on higher costs as its customers are willing to pay a little more for their favorite perfumes and cosmetics. Net margins are flat at 15.5% and stocks have outperformed the index over the past year despite concerns about declining demand from Asian consumers.

The list of companies claiming to have pricing power is too long. It’s time to question the numbers, take a close look at the costs, and maybe think more creatively. While my mom worried about how she was going to pay the growing grocery bill, I was happily distracted, watching Western TV, Casey jones.

Casey was the Cannonball Express engineer for the Midwest and Central Railroad. He had an unusually stressful job. Being held hostage by mail thieves, outwitting thieves in search of gold bars, and fending off the Apaches was a day’s work (although I don’t recall he ever asking for a raise).

American railways still distract my attention today. The system is very different there from that of the United Kingdom. Beyond the suburban neighborhoods of large cities, the main activity of the railways is the transport of goods, not people.

The United States has about 700 companies, but most of them are small (literally in the case of the true Midwest Central Railroad, which is a narrow gauge heritage line). We have interests in two of the largest, Norfolk Southern and Union Pacific, which each span more than 20 states, cover more than 30,000 miles of track and benefit from the recovery of the US national economy.

Union Pacific reported third quarter results last month and reported operating revenue of $ 5.6 billion, up 13%. This is the income before costs are taken into account. Rising fuel costs were a drag, but the company still managed to increase operating profit – profit after costs – by 20 percent. This is an example of a company that manages to pass on increased costs.

He’s also the one who finds ways to cut costs. America’s best railroads have consistently invested in technology in recent years. Today, high-tech precision scheduling enables railways to run longer, heavier trains – and to do so more safely. Union Pacific says that over the past year it has increased the average maximum length of its trains by 4% to 9,359 feet. You may need to read this sentence again. Yes, that equates to 1.77 miles long.

It may not appeal to frustrated drivers stuck at level crossings waiting for them to pass, but longer trains help reduce the industry’s carbon footprint. Almost half of all long-haul freight in the United States is transported by rail, but it produces less than a tenth of freight’s carbon emissions. Union Pacific and Norfolk Southern both say they move one ton of freight 444 miles on just one gallon of diesel.

The industry continues to invest to improve its sustainability. Help the environment and protect investors against inflation. I’m sure Casey Jones would love to hear it.

Simon Edelsten is co-manager of the Mid Wynd International Investment Trust and the Artemis Global Select Fund


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