Inflation

Inflation is a critical concept when it comes to investing, and as Buffet has said, can have a devastating impact on investing returns. There are instruments specifically designed to protect against inflation, like TIPS (Treasury Inflation Protected Security), but companies can also have inflation protection built in to protect revenue and profitability.

We explore companies under our coverage that a proactive approach, or a moat, to protect themselves from rising inflation. 

Companies that perform well in inflationary environments

Traditionally, in inflationary environments companies that have real assets perform well when inflation is rising, such as commodities and real estate. However, there are also companies that take a proactive approach to protect themselves from rising inflation. 

This proactive approach is most common in infrastructure and energy companies, where they have measures protecting their earnings from inflation written into contracts. One of these companies is Transurban (ASX:TCL)—a major toll road investor with concessions to operate 14 Australian and three North American motorways. Concessions grant the right to operate the roads and collect tolls for predetermined amounts of time, and these are usually extremely large sums of money over a long period of time. As you can imagine, changes to inflation could have significant impacts to earnings for a company like Transurban.

Typically, concession life and toll profiles are set in negotiation prior to the road's construction, with the intention of providing a fair return for investors. To provide this fair return, tolls increase in line with the consumer price index or at an agreed fixed rate, though some roads with meaningful competition have dynamic tolling, such as Transurban's U.S. investments. This means that Transurban and its investors have meaningful protection in inflationary environments.

Another company is Sydney Airport (ASX:SYD). Like most publicly traded airports, it further capitalises its dominance through unregulated income streams like retail, car parking, land development. The company contracts out a high portion of its retail store space, and collects minimum guaranteed rent, that’s linked to CPI or passenger numbers, plus additional concession above this threshold. Sydney Airport doesn’t break its retail profitability down, but our analyst who covers Sydney Airport, Alex Prineas, thinks that retail and car parking segments have significantly higher profitability compared to their aeronautical revenue. For investors, this means decent protection from any significant changes in inflation.

The proactive approach aside, there are businesses that have intrinsic protection because of the strengths of their business—in other words, moats (a moat is a source of sustainable competitive advantage that can protect a company’s future earnings). There are two notable factors that will protect companies in this environment, where prices are rising. One of those is pricing power, which can be attributed to most sources of moat.

Although we’re talking about keeping up with inflation, when inflation is abnormal, pricing power is an invaluable benefit of a moat. We’re looking for businesses that can continue to maintain revenue without drastically impacting demand for their product or service, whether that be raising prices, or reducing costs.

One of these businesses is Wesfarmers (ASX:WES). Of course—moats are not the only consideration for a good investment—you must also look at valuation, but we expect it to achieve excess returns for at least twenty years.

Wesfarmers is a wide-moat company largely due to cost advantages from the significant scale, and the difficult-to-replicate store locations of its Bunnings business, which represents over half of group operating income after its demerger from Coles. Bunnings dominates the Australian home improvement retail sector and we estimate its market share close to 25%.

We believe that Bunnings has pricing power because of its efficient scale—another source of moat. Bunnings' scale generates significant bargaining power with suppliers, for examples, when sourcing products or negotiating rents with landlords. The chain passes along a large portion of these savings and operating efficiencies to its customers. Bunnings’ strategy has been to grow volumes over profit margins, broadening its range, investing in service and continuously cutting prices to grab market share and build a loyal customer base.

Instead of increasing prices to maintain revenue, Bunnings have the ability to drive costs down.

Then, there’s intangible assets. Brand is an intangible asset for a company, and is a huge driver of price, and the ability for a company to charge consumers a premium for their product.

In Morningstar’s view, Starbucks Corporation (NAS:SBUX) has brand strength, attractive unit-level economics, it’s successfully replicated its business internationally, and strong results in the retail channel underpinning its brand as an intangible asset. Starbucks has an ability to generate excitement and traffic, and we see this through its impressive comparable sales growth in the core U.S. market, while spending less on marketing than category peers, reinforcing the importance of the brand and its impact on results.

View our Global Best Ideas List and Australian stocks with moats.