6 inflation-tough stocks for global investors

-- | 08/11/2021

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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Here today to discuss some key takeaways from earnings season and to talk about which companies are best equipped to manage supply issues and inflationary pressure is Dave Sekera. Dave's Morningstar's chief market strategist. 

Hi, Dave. Let's start out by talking about what have you been listening for from companies during this earning season so far?

Dave Sekera: Hey, Susan. So, as you know, as long-term investors, we're not necessarily really all that concerned about whether a company beats or misses consensus earnings estimates by a few pennies one way or the other in any individual quarter. What we're really more interested in is: What were those underlying factors that led to that beat or miss? And then depending on that analysis, our analytical team will decide if those factors impact our long-term investment thesis and forecasts or if it's just short-term quarterly noise.

Now this quarter, I'm particularly interested in commentary from management regarding the impact of inflation and then management's expectations for further inflationary pressures. I'm especially interested to find out which companies have the pricing power to quickly raise prices and pass through those higher costs, as opposed to which of those companies will end up seeing their margins compress. I'm also interested in whether or not supply disruptions have impacted a company's operations. And if so, how will those impacts play out over the next couple of quarters and how soon will those disruptions be resolved?

So while we think most disruptions should work themselves out in the next couple of quarters, my concern is that some of those disruptions may be more systemic in nature and take longer to be resolved, which in those cases we would certainly see the valuations on those stocks come down.

Susan Dziubinski: Now, there's still some debate, of course, whether inflation is transitory or whether it's going to be here for a little while, but either way, which types of companies do you think are in the best position to deal with any ongoing inflationary pressure or supply disruptions?

Dave Sekera: Well, first I would look for those firms that we think have long-term sustainable competitive advantages--those that we rate with either a narrow or, more preferably, a wide economic moat. Now, part of the reason that we prefer companies with a wide economic moat is that we expect they'll be able to pass through cost increases more quickly than those companies without those advantages. So as such, those companies with economic moats will be able to maintain their operating margins, even in an inflationary environment. Whereas those no-moat companies will end up experiencing margin compression and likely lead to lower valuations.

Now, the second part to that question, of course, is we always would recommend those companies that we think are either undervalued or at least fairly valued. Now over the past couple of quarters, we've noticed across our coverage is that those companies we rate with wide economic moats generally are either fairly or slightly undervalued as a group at this point in time, whereas companies without those long-term, sustainable competitive advantages are either generally overvalued or fully valued in today's marketplace.

Susan Dziubinski: Let's name some names here, Dave. Let's talk a little bit about some of those undervalued stocks in particular that are moaty and that we feel have that pricing power and then they therefore may be able to pass along any necessary price increases to the consumer. You have a few names in the beverage space in particular, right?

Dave Sekera: There are. So there's actually three wide-moat companies that I'd highlight that I think are both undervalued and have strong pricing power. So first is Anheuser-Busch InBev BUD, which I would also note is one of the only 5-star stocks or one of the few 5-star stocks that we have left trading here in the U.S. And then the other two I'd highlight are Constellation Brands STZ and Coca-Cola KO.

Now across all three of these firms, each do have a significant amount of intangible assets, specifically their strong brands, which underpin their wide moat ratings and provide the firms with strong pricing power. So, for example, historically, both Budweiser and Coke have been price leaders in their individual categories as consumers do highly value their brands. Now only after they put through price increases have we then seen competitors try to follow suit, sometimes successfully and sometimes not.

Now, in addition to the pricing power, we also expect that as the pandemic continues to subside, on-premise consumption will increase back toward normalized levels and that will end up help boosting each of these three companies' performance over the foreseeable future, as what we found is that consumers are more brand-conscious when they order in public, as well as we'll see an increase in overall volume levels as well.

Now, in addition to just the power to raise prices, these firms also have the scale and the purchasing power to be able to better negotiate pricing and terms with their own suppliers. Now, we've talked a little bit about supply disruptions earlier, but even more importantly right now than price, these firms are large enough and meaningful enough to their own suppliers that they've been able to secure the raw materials that they will need to produce their products. Whereas what we're hearing from some of the other smaller competitors is not only are they seeing their costs rise, but they've actually had problems even getting the raw materials that they need to make their own products and may end up having to lower their own production levels.

Susan Dziubinski: And let's talk a little bit now about the technology area and some tech-related stocks. Here, again, what are some moaty names undervalued that, again, have that pricing power that we're looking for?

Dave Sekera: Well, the first one I'd like to highlight is going to be Microsoft MSFT, and everyone knows Microsoft as the dominant provider of office software. And thus far, what we've seen is the software business really hasn't been impacted by commodity prices or supply disruptions. Hardware is a relatively small portion of Microsoft overall business, but even there, the demand for gaming consoles going into the holiday season has been so great that I don't see Microsoft will have any problem putting through price increases there to cover the costs for increased semiconductor costs. Now, Microsoft has also been implementing price increases this year, and those have stuck and have helped boost earnings. In fact, following the third-quarter earnings results, we bumped up our fair value by 6% on this 4-star-rated stock.

Next up would be Facebook FB. Now, this one's interesting in that Facebook's third-quarter earnings were actually below market consensus this past quarter, and the stock did sell off following that news, but we only marginally lowered our fair value. So in this case that sell-off was prompted by changes that Apple had made in their privacy measure. And that made it more difficult to be able to measure the performance of ads purchased on the Facebook platforms.

Now, in our view, we think that's a short-term issue and that Facebook has already begun to address and make some of the changes in order to fix that. Now over the long term, we do continue to expect that Facebook will benefit from the structural shift, the online advertising, the ongoing rebound in economic activity, and what we've seen as far as record-setting new business formations. I expect that Facebook probably has some of the strongest pricing power across the digital space, as online advertising provides businesses with the most efficient and targeted promotions and few companies can offer the depth of consumer data that Facebook has. In fact, we actually continue to view that 4-star-rated stock as probably the most attractive social-media stock under our coverage.

And finally, while technically it's not a tech company, I would actually also include Amazon AMZN in this discussion. And what we see with Amazon is that much of its value proposition is the convenience factor of ordering items online and having them delivered to at home. So we suspect that Amazon won't have any problem passing through their own cost increases to their clients. Then also based on Amazon's size, they will be able to exercise significantly more purchasing power and better supply arrangements than most of the traditional retail competitors. And I think that'll be especially important this holiday season as we're already hearing about the lack of inventory across many other retailers. We think Amazon is undervalued and currently rate the stock with 4 stars.

Susan Dziubinski: Well, Dave, thank you for your time today, not only for helping us put earnings in perspective but also giving us some ideas of stocks that might have the pricing powers to stand up against inflation. And they're under value, too. We appreciate it.

Dave Sekera: All right. Well, thank you, Susan. I appreciate the time.

Susan Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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