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Seven quality companies for the core of your portfolio

In a volatile market, quality companies will continue to shine.

Outlier views in investing – those left-field calls that seem batty at the time – can be highly profitable. Contrarians who successfully bet against the consensus view win big.

I like well-reasoned outlier views that challenge the consensus. Most are easily dismissed, but they force you to consider your view and any biases within it.

A recent outlier view that caught my attention predicts a global inflation outbreak in 2021. Maybe not a 1970s-style shock, but a faster increase in inflation than markets expect.

Yes, the prospect of sharply higher prices seems far-fetched in a recessed global economy. Bank of England research released in July found inflation receded after previous pandemics.

Thanks to the Coronavirus, the June quarter fall in Australian inflation was the largest on record. Technically, the nation had deflation (falling prices) for the first time in 22 years.

Falling fuel prices and sharply lower childcare activity in the early stages of the pandemic sparked negative inflation. Without those items, inflation would have been barely positive.

Low inflation is no surprise. Australia’s economy is contracting, more than a million are unemployed and wage growth is at its slowest in two decades. The Reserve Bank expects inflation to average 1% to 1.5% over the next two years, given the economy’s spare capacity.

Then there’s Coronavirus uncertainty and its effect on consumer and business sentiment. Heaven help retail spending and business investment if the virus lingers.

Clearly, the consensus view is for low inflation and low interest rates for several years. So why are some experts tipping an inflation breakout in 2021 and is their view realistic?

Much depends on Coronavirus containment. Imagine if a vaccine is found and starts to be distributed within 12 months. And Victoria gets on top of its second COVID-19 wave and other states effectively eradicate the virus this year, in turn re-opening their borders.

Consumers who still have a job are itching to spend money saved from not holidaying overseas, eating at restaurants or going to pubs, clubs and sporting events. Signs that the pandemic is under control unleash massive pent-up consumer demand.

Also, businesses that slowed or stopped investing during the pandemic start spending again. Some have to reconfigure plans and “pivot” for a post COVID-19 world. Others buy weakened competitors or spend more on advertising and other products and services.

Governments realise they provided too much fiscal stimulus during COVID-19. The result: too much money sloshing around the economy, boosting demand and ultimately prices.

It’s an interesting theory, but I am still in the low inflation/interest rates camp. Inflation was weak before COVID-19 and I cannot see it bursting higher soon after it. But the pandemic’s implications are so profound that an inflation outbreak cannot be discounted entirely.

 

Profiting from higher inflation

Higher inflation has winners and losers. It’s bad for savers (who have less real purchasing power) and those on fixed incomes (unless that income is indexed to inflation rises annually).

Rising inflation also hurts home-loan borrowers with variable mortgage rates (because interest rates usually rise), makes exporters less competitive and creates economic uncertainty.

Winners include people, businesses and governments with high debt because rising inflation makes that debt easier to pay back. Firms that can cut real wages or increase prices during a bout of higher inflation are other potential winners.

Those who believe an inflation outbreak is likely in 2021 should buy gold, base metals and other assets that benefit from rising prices. Those, like me, who expect modest growth in inflation that does not trigger interest rate rises for several years, need to play the trend differently.

My preference is for companies that have pricing power. That is, firms that have a sustainable competitive advantage that allows them to lift prices without crushing demand for their product or service. Firms that can grow without having to boost wages or other costs.

At the right price, these companies should be portfolio mainstays, regardless of inflation. An ability to boost prices, without hurting customer demand, is a rare trait.

Here are seven high-quality companies with latent pricing power:

 

1. Xero (XRO)

A favoured stock of this column, Xero has latent pricing power because accounting software has high switching costs. Simply, it’s a pain for customers to change provider once they install and get used to an accounting software package for their business.

Would users ditch the software and move to a rival if Xero lifted prices by 5%? My bet is most users would stay because of the convenience, functionality and value of Xero software.

 

Chart 1: Xero

Source: ASX

 

2. REA Group (REA)

The property advertising group has pricing power because of its “network effect”. More users attract advertisers to its site, which in turns attracts new users and new advertisers.
The network effect becomes a formidable barrier to entry for rivals.

REA, by far the dominant platform in its market, can lift prices because property advertisers have to use it if they want to reach enough prospective customers.

REA has lifted prices successfully in previous property downturns. As real estate agents grumble about higher advertising costs, REA goes from strength to strength.

REA this month reported another respectable full-year result in a tough property market.

 

Chart 2: REA

Source: ASX

 

3. Carsales.com (CRZ)

The car-advertising platform, another column favourite, benefits from a similar network effect to REA Group. Its domination of car listings in Australia provides some pricing power.

Granted, it is hard for Carsales.com to lift prices in the troubled auto-retailing industry, but that could change quickly post COVID-19 as the economy rebounds and car demand keeps improving.

 

Chart 3: Carsales.com


Source: ASX

 

4. Magellan Financial Group (MFG)

The wealth manager’s pricing power comes from its brand strength. Magellan is hardly immune to industry trends to cut fees. Active fund managers are under growing pressure to cut fees as passive Exchange Traded Funds and other low-cost funds increase their market share.

But Magellan has a legion of loyal followers and financial advisers who swear by its international equity funds, long-term performance and brand. That makes Magellan better placed to resist fee pressure than most of its peers.

 

Chart 4: Magellan

Source: ASX

 

5. CSL (CSL)

The global biotechnology company derives its pricing power from exceptional intellectual property (IP) and investment in research and development (R&D). The scale of its R&D is hard for new entrants to replicate and a significant barrier to entry into its markets.

At a product level, CSL’s IP protects its high margins from competitors and creates royalties from other companies that use aspects of its technology.

CSL is not cheap. But as Warren Buffet said, the single most important decision in any stock evaluation is the company’s pricing power, of which CSL has plenty.

 

Chart 5: CSL

Source: ASX

 

6. Domino’s Pizza Enterprises (DMP)/Collins Foods (CKF)

The fast-food giants’ operational scale drives their pricing power. Small pizza operators would go broke if they sold $5 pizzas as Domino’s does in its value range. So too would chicken shops that sold two pieces of chicken, chips, a bread roll, mashed potato and a soft drink for $4.95.

Love or loathe them, Domino’s and Collins (owner of KFC stores) offer undeniable value to their target market. My guess is Collins could lift prices by 5% next year and most KFC lovers would still line up for their fried-chicken fix. Some would not even notice the change.

 

Chart 6: Collins Food

Source: ASX

 

7. ASX (ASX)

The Australian Securities Exchange gets its pricing power from its dominant position in local financial markets. It is hard to see that position eroded anytime soon by competitors.

Companies and market operators would grumble if ASX lifted fees in a recessed economy. The exchange has cut some fees but has the firepower to lift its charges if needed.

 

Chart 7: ASX

Source: ASX