Three core characteristics help quality companies combat inflation
At Ninety One, the businesses that our Quality team invests in display three core characteristics that should offer protection from any prolonged inflationary pressures: They have significant pricing power given their strong competitive positions. They are low capital intensity businesses, backed by intangible assets. They have healthy balance sheets, insulating them from rising financing costs.
Pricing power helps mitigate the risks of disruption
We define high-quality companies as those with enduring competitive advantages that are derived from intangible assets such as brand, intellectual property, unique content, and networks. These qualities provide these companies with barriers to entry and – crucially – pricing power, which in turn enables them to deliver long-term structural growth and resilience, irrespective of whether the environment is inflationary. They also compound cash flows at sustainably high levels of profitability.
Some companies possess explicit pricing power through offering critical products and services, while others have commission-based revenue models, where percentage take rates enable rising transaction prices to transfer fully through to revenues. Another form of pricing power comes from strong brands and premium category positioning. Supply disruption can have a meaningful impact on consumer goods companies with complex global supply chains and tightly managed working capital cycles. However, businesses with large portfolios of dominant brands in attractive categories with market-leading distribution are well placed to mitigate the risks of disruption and input cost inflation.
Lower capital intensity businesses have better protected cash flows
The conventional wisdom often cited during inflationary times is to invest in capital-intensive businesses such as those in the energy and commodity sectors, which – as we have seen so far this year – benefit from inflation in the commodities they produce and sell. However, we believe lower-quality capital intensive companies with high fixed-cost bases may struggle longer term during inflationary periods. This is because they have significant reinvestment requirements to maintain their physical assets such as buildings and machinery, and inflation in capex inevitably eats into cash flows.
We believe high quality, capital light businesses with much lower capital expenditure requirements will be better protected in an inflationary environment. These companies can sustain profitable free cash flow growth which, in turn, can be reinvested into the business to fund future growth or be distributed to shareholders in the form of dividends or buybacks. We believe such businesses are not only better equipped to survive during periods of inflation but can also thrive.
Healthy balance sheets mean lower financing costs
Another benefit of quality companies with typically stronger balance sheets is that they will be less impacted by higher financing costs as rates rise and will actually benefit directly from higher rates where they have net cash on their balance sheet.
Through these attributes, we remain confident that our approach will be well-equipped to perform well through an inflationary environment and be resilient should there be any periods of market weakness. The entire team shares a consistent investment philosophy, which ensures that all research ideas centre around those companies with pricing power, low capital intensity and healthy balance sheets. We believe such businesses are well set to compound shareholder wealth in real terms irrespective of the macro environment and will continue to do so if prices rise for a prolonged period.
