Seven stocks to consider as inflation bites into profit margins for investors

High inflation data is inevitably followed by stories about companies with “pricing power”. The goal is to own companies that can lift prices to maintain their profit margin as costs rise, without denting demand for their product.

If only it were that simple. The market is aware of companies with pricing power and values them accordingly. REA Group (REA), for example, has pricing power due to its dominance in property advertising. REA trades on a forward Price Earnings (PE) multiple of over 40 times.

It’s no good buying a company with pricing power if it is overvalued. As investors clamour for a small group of companies with genuine sustainable competitive advantages (and thus pricing power), valuation risks rise.

Now consider the reverse: companies with low pricing power. High inflation can sometimes help rather than hinder lower-quality firms. They’re able to pass on price rises because consumers expect – and begrudgingly accept – higher prices. 

A self-perpetuating inflation cycle builds: workers expect rising living costs, so push for wage rises. Companies expect higher costs, so lift prices. They start lifting prices because they are worried competitors will. I doubt we will see a return to this self-perpetuating ‘70s-style price shock, but inflation can lift a lot of tides. 

Consider, too, sectors hardest hit by high inflation. Discretionary retail is a classic. Fashion retailers face rising material, energy and wage costs that crimp skinny margins. Many retailers struggle to pass on price rises in a hyper-competitive market. 

Several retailers this year have reported growing margin pressure. Their shares have tumbled as a result – too much, in some cases. So, a sector with low pricing power looks interesting because the market has overreacted to the inflation threat.

In last week’s Federal Budget, the Government again pumped more money into the economy through one-off payments and a cut in fuel excise. That’s good for retailers.

Technology is another example. In theory, the tech sector is a loser from rising inflation and interest rates. Higher rates reduce the value of future cash flows and net present values. They’re bad for tech and other long-duration growth stocks.

Yet the companies with arguably the strongest pricing power are in technology. Would you cancel your Netflix subscription if its price increased by $1? Would you stop using Apple products if its prices rose 5%? Would your small business stop using Google for search-engine advertising or Facebook for ads if their prices rose slightly?

To my thinking, the big US tech stocks have significant latent pricing power. People pay $1,200 for an Apple smartphone because it’s worth a lot more than that to them. They can no longer function each day, professionally or personally, without one.

Also, it’s too simplistic to buy stocks just on their pricing-power capabilities.  Woolworths has inflation-beating qualities due to its scale and efficiency. But many consumers will put less in their trolley if living costs rise. 

Those who want to invest thematically based on company pricing power are better off using ETFs over sectors or themes. Banks, a favoured sector of mine, commodities and gold are the best sector bets if inflation stays higher for longer. 

Another option is using Smart-Beta ETFs that choose companies based on factors, such as quality, value, size or momentum. Smart-Beta Quality ETFs have been popular this year as heightened market volatility encourages ownership of the higher-quality companies. This quality often equates to company pricing power.

Agriculture is another interesting play on rising inflation. The BetaShares Agriculture ETF (FOOD) is a useful tool for diversified food-stock exposure.

For investors who prefer to own ASX-listed companies with higher pricing power, here are 7 ideas to consider:

 

1. Fast Food: Domino’s Pizza Enterprises (DMP)

Source: ASX

 

Big fast-food operators like Domino’s Pizza Enterprises (DMP) and Collins Foods (CKF) (who operates KFC restaurants) face rising input costs and have thin profit margins. But when prices for dearer takeaway food increase, watch more people trade down to Domino’s and KFC. 

Both companies have scope to lift menu prices if needed without crushing demand for their product. Base items on their menus ($5 pizzas, for example) are undeniably good value (if not always undeniably tasty). Customer loyalty is another factor.

 

2. Accounting software: Xero (XRO)

Source: ASX

 

If my accounting-software provider lifted its monthly subscription by 5%, I’d pay it without hesitation. Installing new accounting software and learning how to use it is a time-consuming pain. That’s the beauty of selling products with high switching costs.

Accounting software is less affected by rising material and energy costs than most sectors. Rising wages are an issue for all tech companies, but accounting software tends to have fat margins and recurring annual revenue. 

Xero is the pick of the accounting-software providers, particularly after falling about a third from its 52-week high. Like other tech stocks, Xero has underperformed this year, even though its product and recurring revenue are attractive in a volatile market. 

 

3. Alcohol: Endeavour (EDV)

Source: ASX

 

Alcohol stocks are an interesting way to play rising inflation. Premium producers have some pricing power. Many customers still want (or need) their favourite boutique beer, wine or spirit, even if prices rise a little. 

Endeavour Group (EDV) is my preference. Some will disagree with the inclusion of Endeavour, owner of Dan Murphy’s and BWS, in this list. Higher freight costs are a big issue for alcohol and other retailers of fast-moving consumer goods. But Endeavour’s scale provides an advantage over competitors. 

Endeavour has greater scope to absorb cost pressures and maintain margins. It’s also possible that as alcohol prices rise, more consumers will ditch their local bottle shop for Dan Murphy’s, which is perceived as the lowest-cost provider. 

 

4. Education: IDP (IEL) 

Source: ASX

 

When inflation was low, many private schools passed on annual fee increases of 3-5%. The ability to lift prices at two to three times the inflation rate shows the latent pricing power in education. Changing schools can have high switching costs (particularly if kids are settled and happy at their existing school). 

The same is true of tertiary education. Fees for my Master’s degree rose noticeably this year, but I kept paying. When you’re halfway through a degree, you have to keep going, even if prices rise. Again, that’s the power of high switching costs. 

IDP Education is one of my favourite stocks. I’ve highlighted IDP’s positive traits many times over the years. IDP’s 5-year average annualised total return is 47%.

I doubt demand for IDP’s English language-testing services would fall if it raised prices a little. Or that universities would stop using IDP to place international students. Right or wrong, education is an industry that has strong form in passing on higher prices – and customers who cop higher education costs. 

 

5. Health: ResMed (RMD) 

Source: ASX

 

The defensive qualities of healthcare stand out in an inflation environment. When prices rise, people still need medical services and equipment. However, I’m not convinced price inelasticity in healthcare is as strong as it was: there are reports of people cutting back on prescription medicine and other health services due to rising prices.

I like big medical-device makers that have customers for life. ResMed is an example. Would someone who relies on a ResMed Continuous Positive Airway Pressure (CPAP) machine to breathe during sleep pay more for a new device if needed? Probably. 

ResMed’s technology innovation provides a degree of pricing power. Customers know the machines keep improving, so will pay more for upgraded models.

ResMed has fallen from a 52-week high of $40.47 to $31.26. Morningstar values ResMed at $35, suggesting it is modestly undervalued. If you want high quality, ResMed is up there with the best and recent price falls have improved the entry point.

 

6. Data: NEXTDC (NXT)

Source: ASX

 

If data is the most precious asset in the 21st Century, data storage surely has latent pricing power. Having outsourced data storage to a third-party data centre, or to the cloud, customers are reluctant to change providers. Would you change your cloud-computing storage provider if its fee rose a little? Would a company change data centres if its price rose?

Maybe. But I’m betting that NEXTDC, a leading data-centre provider, has reasonable pricing power if it needs to lift fees to account for higher energy costs. Data centres use a lot of water and energy for cooling.

NEXTDC has fallen from a 52-week high of $14.09 to $11.20. For a stock that rose consistently for years, the pullback is an opportunity for prospective investors. A consensus price target of $14.05 among broker firms that cover NEXTDC suggests it is undervalued at the current price.

Pricing power aside, demand for data storage has excellent long-term growth prospects. More companies will store a lot more data in coming years as semiconductor chips in products capture information and artificial intelligence analyses it. Growing use of video will also drive higher data-storage demand.

 

7. Online marketplaces: SEEK (SEK)

Source: ASX 

 

REA Group, Seek and Carsales.com have pricing power due to their market dominance. Real estate agents and home vendors might grumble when REA lifts advertising fees, but they risk missing a large section of buyers if they avoid realestate.com.au

I’m in two minds about nominating Seek as the preferred platform play with pricing power. On a forward PE of over 40 times FY22 earnings (based on consensus estimates), Seek’s valuation leaves little room for error. Rising competition for job ads – LinkedIn and other platforms have emerged – is a consideration.

However, in a story about pricing power, it’s hard to exclude Seek when companies are scrambling for workers. Seek could lift its prices a little and companies would still use its platform to advertise for workers, such is their need for labour.

A consensus analyst target of $34.30 suggests Seek is modestly undervalued at the current $29.32. The consensus looks too bullish but Seek is a high-quality company in a market (employment advertising) that has good growth prospects.

 

 

Tony Featherstone is an expert contributor to The Switzer Report. All prices and analysis at 31 March 2022. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.