The critical question to ask in 2021

We believe the one thing investors cannot ignore in 2021 is whether the businesses they are invested in have pricing power.

Many people are forecasting an increase in inflation over the next several years. In fact, central banks are telling markets they are willing to let inflation ‘run hot’ to achieve some level of average inflation over a period of time.

It is important to understand there will almost certainly be an acceleration in reported year-over-year inflation from April to June of 2021. This acceleration will not be because inflation is moving structurally higher, but because there was disinflation (positive but slowing inflation) in April to June of 2020 as economies went through the worst of the lockdown. To oversimplify: because inflation was very weak in the second quarter of 2020, merely normalising to something closer to pre-lockdown levels in the second quarter of 2021 will mathematically look like a meaningful year-over-year acceleration.

We believe that focusing on this short-term increase in inflation misses the bigger point. The key issue is whether inflation will structurally run much higher than 2% for several years. The belief that it will is the basis of the ‘reflation’ trade: own commodities and banks, who have a) short-duration cash flows b) at cheaper starting valuations and c) will show tremendous year-over-year growth in earnings in 2021 (due to earnings collapsing in 2020). In addition, if central banks lose control of inflation expectations, owning commodity businesses should (in theory) provide an inflation hedge. We don’t necessarily think this is the best approach.

We approach this issue from a slightly different angle. The primary effect of inflation on a business is that input costs become more expensive. To us, the critical question to ask in such a scenario is ‘can a business pass on the increase in costs by offering its consumer a differentiated good/service?’ In effect, does the business have pricing power to grow its profits in real terms?

To quote Warren Buffett:

The single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business.

Buffett knows this better than most, having managed money during the high-inflation periods of the 1970s and early-1980’s.

If inflation does increase meaningfully (i.e. above 3%), central banks will need to hike interest rates to contain it. While some see this as a utopia for banks (who stand to earn a higher net interest margin), we would point to the increased likelihood of widespread defaults if rates move sharply higher. Moreover, an ongoing increase in inflation will eventually erode the fundamental profitability of capital-heavy business models (such as commodity producers) who need to replace their physical capital at ever-higher price levels.

We do not pretend to know the magnitude of inflation over the next several years, though we suspect it will remain contained. We do think the best real assets to own in such an environment are those that have strong balance sheets, are capital-light and have pricing power: in short, high-quality businesses. 

One thing investors can't ignore in 2021

The above wire is part of Livewire's exclusive series titled "The one thing investors can't ignore in 2021." The series will culminate in the release of a dedicated eBook that will be sent to readers on Monday 21 December. You can stay up to date with all of my latest insights by hitting the follow button below.