This week’s inflation report was extraordinary, putting the US on track for its biggest increase since 1981. As it coincides with the beginning of earnings season, investors are wondering how it will impact companies’ bottom lines. The short answer is that it depends.
Higher prices add hurdles for companies. While inflation often boosts revenues, a company’s nominal profits must grow fast to stay ahead of rising costs. At moderate inflation levels, earnings tend to outpace prices. Our research shows when inflation was between 2% and 4% per year, US companies delivered real earnings growth of about 8.8% per year since 1965. We’ve observed similar trends for global companies over a shorter time span.
But can companies maintain earnings growth in the environment we’re facing? Measures of profitability point to the challenges. Today, global net income margins are extremely high (Display). The combination of high margins, slowing growth and input cost pressure will squeeze profitability for many companies, in our view. Equity investors must find companies that can maintain margins should these conditions persist.
We believe this will be a key differentiator of long-term equity return potential in the new inflationary world. Our research also indicates that the dispersion of returns tends to be wider during periods of higher inflation. A wider dispersion usually provides active managers with attractive opportunities to find companies with better return potential.
To do so, investors must identify the microeconomic impacts of inflation that affect business outlooks, cash-flow potential and future returns. Across industries and markets, two key questions can help frame the analysis.
How are input costs evolving? Many companies that are meeting revenue expectations are facing earnings downgrades because of rising costs. Those that can substitute cheaper input sources will have an advantage in maintaining margins as prices rise. Companies capable of restructuring manufacturing processes and supply chains will also be better placed to preserve profitability.
Does the company have pricing power? Pricing power is always an important indicator of a quality business, but even more when inflation runs high. Look for conservative companies that don’t make sharp shifts in guidance. Consistency of recent profit margins is another good sign of pricing power. Companies with long-term secular catalysts for their business, such as environmental efforts or technological adoption, are also better equipped to push prices higher without sacrificing demand.
These questions can guide investors to the right companies for the new regime. Since most of the asset-management industry’s quantitative models were developed after the high inflation of the 1970s, they’re designed for a deflationary regime and might not provide reliable indicators for the future. And because the effects of inflation on companies are complex, we believe comprehensive fundamental analysis that emphasizes high-quality features is essential to find companies that will endure tougher conditions.
With a disciplined approach to company fundamentals that puts inflationary threats and opportunities front and center, we believe investors can gain confidence in positioning for the complex times ahead.