Getting inflationary investing back on track
As a child of the 1960s and 1970s, I remember my mother peering into her purse worrying about how she could stretch the household income to cope with inflation. She had an encyclopedic knowledge of supermarket prices, built from years of economising.
The worst point was 1975, when inflation peaked at 24.2 per cent. For much of the past 25 years it has hovered at around 2 per cent. To many of those finding double-digit increases in energy bills and at the petrol pump, this new period of inflation may come as a shock.
The factors driving it have evolved over the past six months. In the spring, prices were compared with those of a year earlier, in the depths of the first lockdown. It was not surprising if the prices of, say, second-hand cars were sharply higher. A car, second-hand or not, was of little value during lockdown.
More recently, price rises seem to have been the result of scarcity, as companies struggle to keep pace with recovery. Tales of port blockages and driver shortages are global. Some of these blockages will no doubt start to clear, but others seem likely to persist.
The other big factor is wage inflation. Most of us have been happy just to be in work during the past couple of years, so there has been little pressure for wage increases. Now it is time for catch-up.
Mix into this the way Covid-19 has led many to review whether they really need that low-paid job and suddenly many major employers are having to ratchet up wages significantly to attract and retain workers. Inflation, whether from wages, fuel or raw materials, reduces company margins, especially if not accompanied by booming economic conditions.
How should this affect your choice of equity holdings? Some sectors, such as the hotel and entertainment trades, are enjoying a recovery, but rising labour and energy costs are squeezing profit margins. Share prices of many companies in these sectors have flatlined.
Other sectors’ reputations for coping with inflation may prove exaggerated. Makers of popular consumer goods, for instance, tend to insist that their brands are strong enough to pass on any inflation costs in higher prices. The evidence suggests this is not always the case.
Take Beiersdorf, which makes Nivea cosmetics. Analysts expect its operating margin (sales less the cost of making and selling the goods) to fall from 15 per cent in 2019 to around 12.8 per cent this year, according to Bloomberg. A small fall in operating margins may have a large impact on what is left for shareholders after interest and tax have been deducted — the net profit margin for Beiersdorf is falling from 10 per cent to about 9 per cent of sales.
This partly explains why the shares have underperformed the global equity index by 25 per cent 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.
By way of contrast, L’Oréal, one of our favourite holdings, seems able to pass on higher costs as their customers are prepared to pay a little more for their favourite perfumes and cosmetics. Net income margins are steady at 15.5 per cent and the shares have outperformed the index over the past year despite worries about fading demand from Asian consumers.
The list of companies that claim to have “pricing power” is unrealistically long. It is time to question the numbers, examine costs closely and perhaps think more creatively. While my mother was worrying about how she was going to pay for the rising grocery bill, I was happily distracted, watching the TV Western, Casey Jones.
Casey was the engineer on the Cannonball Express for the Midwest and Central Railroad. He had an unusually stressful job. Being taken hostage by mail robbers, foiling thieves looking for gold bullion and fending off Apaches was all in a day’s work (though I don’t recall him ever asking for a pay rise).
US railroads still divert my attention today. The system there is very different from the UK’s. Beyond the commuter districts of big cities, the main business of railroads is carrying freight, not people.
The US has about 700 companies, but most are small (literally in the case of the real Midwest Central Railroad, which is a narrow-gauge heritage line). We have holdings in two of the largest — Norfolk Southern and Union Pacific — each of which spans more than 20 states, covers more than 30,000 miles of track and is benefiting from the recovery in the US domestic economy.
Union Pacific announced its third-quarter results last month and reported operating revenue of $5.6bn — up 13 per cent. That is income before costs are taken into consideration. Rising fuel costs proved a drag, but the company still managed to achieve an increase in operating income — profit after costs — of 20 per cent. This is an example of a company that is managing to pass on rising costs.
It is also one that is finding ways to reduce costs. The best US railroads have consistently invested in technology in recent years. Today, high-tech precision scheduling enables railroads to run longer, heavier trains — and to do so more safely. Union Pacific says that in the past year it has increased its average maximum train length by 4 per cent to 9,359 feet. You may need to re-read that sentence. Yes, that works out at 1.77 miles long.
This may not please frustrated drivers stuck at railway crossings waiting for them to pass, but longer trains are helping reduce the industry’s carbon footprint. Nearly half of all long-distance freight in the US is carried by rail, yet it produces less than one-tenth of freight carbon emissions. Union Pacific and Norfolk Southern both say they move a ton of freight 444 miles on a single gallon of diesel.
The industry continues to invest to improve its sustainability. Helping the environment and protecting investors from inflation. I’m sure Casey Jones would be pleased to hear it.
Simon Edelsten is co-manager of the Mid Wynd International Investment Trust and the Artemis Global Select Fund