Abnormal profits: Why they're coming and where to find them

A bunch of global companies should get a handy bump from the trade-off between commodity prices and their own price increases, says Ellerston Capital's head of small and mid-caps Bill Pridham.

“If costs stay flat relative to where they are today, you’re going to get some abnormal profits coming through next year, on the margin side of things,” he said.

As Pridham explains, companies who have already lifted prices will get the full 12 months’ annualised benefit of those increases. As an example, he points to bedding manufacturer Tempur Sealy – currently one of his portfolio’s largest position. Management has indicated around half of their recent price increases will flow through into next year.

“And if commodity costs stay where they are, even at these elevated levels, they’ll get margin growth on top of that,” Pridham says.

“But imagine if those commodity costs come down. The bedding industry doesn’t give those back.”

Rather than obsessing over the “transitory versus structural” debate, this is where the rubber hits the road for global small caps vis-à-vis inflation.

In the following interview, Pridham explains how to spot companies likely to benefit from this inflation-linked margin uplift.

Transcript

What are the big topics occupying your team right now?

The biggest topic right now, James, is inflation and it's not whether it's transitory or not. Look, everybody's got their view around that. I think from what we're hearing from our companies is that costs are going up, supply chain bottlenecks are still there, but the debate around inflation, like I said, it's not the transitory aspect. It's whether our companies can pass that through, whether our companies are that weak link in the supply chain. And that's something that we look at, debate, talk through constantly to make sure we're not that weak link. Because somebody's going to where that margin pressure through this, and it's something that we're really laser focused on at the moment. And one thing though on the flip side of that is companies that are raising prices now, they've been staggered throughout the year, and what we're going to see next year, and I don't think too many people are talking about this just yet, is that they're going to get the full year annualised benefit from those pricing increases.

If costs and commodity costs stay flat where they are today, you're going to get some abnormal profits coming through next year in the margin side of things. And we literally talked to Tempur-Sealy this morning, it's one of my largest positions, and they have been raising prices throughout the year to totally offset the cost inflation, and they're saying that roughly half of that price increase will flow through to next year. And if commodity costs stay where they are, even at these elevated levels, they'll get margin growth on top of that. But imagine if those commodity costs come down. On the call, they said the bedding industry doesn't give those prices back at the end of the day. 

So they're exiting the year with double digit price increase. Half of that flows through to next year. So you've got mid-single digit growth just from that alone and you're going to get the margin benefit from that as well.

So the inflation side of thing, James, transitory or not, that's not the big area of debate. The debate is, can our companies pass it through? We've been talking to a number of our companies over the last few weeks, and that's the high topic of conversation for us, to understand how that works, how it flexes through the P&L. Can they pass it through? And that's the biggest thing that we're trying to look at right now. 

Can companies pass on their raising inflation costs?

The biggest way a company can pass through inflation is market presence. So if they have high market shares, they tend to have the ability to pass through prices. If they're very much a integral component of a supply chain but fairly low cost, they typically can pass through prices. We have looked at our portfolio and gone through every position on the back of that and everyone that we've talked through right up to date, like I said, even through this morning, they're able to pass that through.

But it really is about that market power at the end of the day in terms of, you talked about the Porter Five Forces and their bargaining power versus supplier base, their bargaining power over their customers. And it really comes down to how mission critical they are for their customers. And that typically will coincide with their market shares at the end of the day. And, thankfully, all of our companies have that capability right now. That's something we look for. And one thing that highlighted through the pandemic period was the essential nature of them, and that underpins that power pricing as well, James. So the majority of the companies that we own were deemed essential through that period, and I think that's showing up in their ability to pass prices through as well.

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Bill manage a concentrated global equity portfolio with a mid/small cap bias based off the highest conviction ideas from a filtered universe of securities that he feels are in a period of ‘Price Discovery’. For further information on the Fund, please visit the Fund Profile below.

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Ellerston Global Mid Small Cap Fund

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