There are a number of key qualities that a company needs to have to be able to navigate a period of high inflation. Most investors and analysts will concentrate on a company’s ability to set prices as the most important inflation-beating factor. While this is not wrong, it is difficult to tell if a company has pricing power before times get tough.
Netflix Inc. (NASDAQ:NFLX) is a great example. Some investors might have argued the company has pricing power as there are not that many streaming alternatives, especially if consumers want to keep costs down. In a challenging economic environment, consumers might cut the number of services they use, but with its huge content library, Netflix seemed well-positioned to win out.
Indeed, in the run-up to its recent subscriber losses, the company had pushed several price hikes onto consumers without any noticeable impact on subscriber numbers. That has now started to change. As the macro backdrop has shifted, so have consumer spending patterns.
There are plenty of other examples, especially in the subscription space. Many companies believed they had something unique, an offering that consumers (or other businesses) would continue to pay for in any environment. That way of thinking is now being seriously challenged.
It might look as if a company has pricing power. Still, until it is tested through an economic cycle, there’s really no way of telling for sure (even then, there’s no guarantee the pricing power will last through another cycle).
With that in mind, here are a couple of other factors investors might want to consider when analyzing if a business can ride out a period of rising prices.
Gross margins can be a cushion against inflation
The first factor to keep an eye out for is high gross margins. These can signify that a company has the pricing power to begin with, but they also show there is room for the business to absorb higher prices. If a business cannot pass higher prices onto consumers, it will have to absorb the cost.
A business with gross margins of 1% or 2% will struggle to absorb the higher costs and it might try to cut costs instead, hurting customer service. A business with margins of 20% or more should be able to absorb costs, maintain a high level of service and should be able to rebuild over time.
Funding will become more expensive
Investors should also review a company’s financial position. Inflation generally leads to higher interest rates and monetary tightening. This means higher borrowing costs for indebted companies and reduced access to borrowing for companies that require lots of working capital (or capital spending).
Further, businesses that rely on equity funding may find themselves struggling to raise capital and investors become more risk-averse.
To get around these issues, investors should consider businesses with enough cash flow to fund spending requirements without having to rely on third parties.
There are good assets and there are bad assets
Generally speaking, hard assets such as real estate provide some protection against inflation. The purchase price of a rental property does not change, but if rents rise with inflation, the income stream from that asset will be inflation-linked. The cost of replacing the asset will also rise, so in the long term, the capital value should increase.
However, assets without inflation-linked cash flows will become more costly to maintain without the inflation uplift.
Historically, the steel sector has been the most susceptible to this theme, but I wonder if cloud computing will feel just as much pain in this cycle. Cloud services have only gotten cheaper over the past two decades, and the technology underpinning the service is getting cheaper as well.
With so much money and competition in the sector, there is no guarantee these cash flows will rise with inflation. That is something to consider.
This article first appeared on GuruFocus.
