As the world economy starts to get back to something approaching normal, and with supply chains struggling to keep pace, inflation has once again reared its head.

From the UK to Europe, the US and China, consumer and producer prices are rising at a faster pace than politicians and central bankers would like.

For investors, this year has been a test of how their portfolios might perform if there were a sustained rise in inflation at some point in the future. Some strategies have held up, while others have fared less well.

We think this could be the time to focus on quality businesses with strong competitive positions and sustainably high returns on capital and margins, with low levels of leverage.

HISTORICAL PRECEDENT

Central bankers in Europe and the US are keen to reassure investors that the current spike in inflation is ‘transitory’, that is the product of short-term supply-side shortages created by  the pandemic.

However, there is a growing divergence among central bankers and treasury officials between the ‘transitory’ camp and those who believe we are at a tipping point ahead of a generational shift higher in prices.

US asset manager GMO recently published a paper showing that quality stocks have tended to perform well compared to the broader US market during times of rising prices, while adding a valuation bias to the stock selection process delivered even better results.

High-quality stocks beat the index in six out of eight inflationary periods and cheaper high-quality stocks beat it in seven out of eight periods. Moreover, in most cases stocks that combined quality and value beat inflation while the broader market lagged rising prices.

GMO’s quality strategy manager Tom Hancock typically invests in relatively high-margin businesses where cost inflation affects a lower proportion of revenues than for the broader market.

‘If we assume that, like death and taxes, cost increases are more reliable than revenue increases, then quality companies’ margins are less at risk than the average,’ says Hancock.

He adds: ‘The reality, however, might be even better, as we would expect the majority of the businesses in which we invest to be able to raise their own sales prices given their entrenched advantages.’

While the firm doesn’t reveal its stock selection process, its quality strategy, which has over $12 billion of assets, has beaten the S&P 500 index and the MSCI World index every year except one (2013) in the past decade, typically by a substantial margin.

Most of the main holdings are asset-light, which means routine maintenance capital expenditure is lower than for the market, and their main assets are intangible so they aren’t directly exposed to factors like commodity prices, although they still need investment in technology.

QUALITY WITH PRICING POWER

One of the most popular funds among UK investors which targets quality stocks is Fundsmith Equity (B41YBW7), which focuses on businesses with sustainably high returns, competitive moats, strong cash flows, little or no debt, and attractive valuations.

Looking at the Fundsmith portfolio at the  end of 2020 – a year when the fund returned 18.3% against 12.3% for the MSCI World index (in pounds) – its superior quality is clear from the table.

Even in a year of such dramatic change, the portfolio’s weighted average return on capital employed was still 25%, more than double that of the S&P 500 and the FTSE 100.

At this year’s annual shareholders’ meeting it was the portfolio’s average 65% gross margin – that is, the difference between revenues and the cost of goods sold – which founder Terry Smith flagged as the biggest indicator that his holdings have pricing power in an inflationary environment.

‘Companies take in goods and services and mark them up before selling them on to customers. Clearly, making something for 35 and selling it for 100 (a gross margin of 65%) is better than making something for 60 and selling it for 100 (see the FTSE 100 gross margin of 39%),’ says Smith.

‘If you get higher inflation, our companies are the kind you want to own,’ he adds. ‘Having high gross margins means they can pass on input cost inflation to their customers. Also, if inflation goes to 10%, our companies have a return on capital of 25% whereas the average FTSE company has a return on capital of 10% and would make no return at all,’ says Smith, assuming higher costs aren’t passed on to customers.

Where rising inflation could impact higher-quality stocks is in terms of valuation, says Smith. More expensive, bond-like stocks are likely to face a greater valuation headwind in an inflationary environment than cheaper, low-quality stocks, but he believes their superior operating performance should compensate for that situation.

GOOD TIMING

Joachim Klement, senior strategist at stockbroker Liberum and the author of Seven Mistakes Every Investor Makes, believes the second quarter earnings season could provide ‘a reality check’ for investors, and recommends tilting portfolios towards quality stocks with high profitability and high margins which are better able to withstand cost pressures.

‘Analysts have upgraded earnings (forecasts) for 2021 at ever-increasing speed. Our analysis shows that in an environment of rapidly rising inflation and long-term bond yields, this is likely to be too optimistic,’ says Klement.

The rapid rise in inflation and long-term bond yields is creating margin pressures for companies which cannot adjust their end customer prices fast enough, meaning a   margin squeeze which could lead to earnings growth disappointing in the second half of the year, he adds.

‘This is currently not priced into analyst earnings expectations and should lead to a weaker phase in markets overall during the second half of this year. In particular, value stocks should underperform as investors re-assess the speed of the recovery.’

Meanwhile, says Klement, quality stocks with high gross margins and returns on capital should be able to cope better with the pressure of rising cost inflation and should start to outperform.

DIFFERENT PORTFOLIOS

Liberum has constructed several ‘factor’ portfolios, each of 20 stocks, equally weighted. Taking the portfolio of low-beta UK stocks with a quality tilt – meaning an attractive mixture of return on equity, return on assets and low gearing or net cash – the top 10 stocks ranked by return on equity throws up some interesting names.

Low beta refers to stocks that are less volatile, or ones that have fewer share price swings, than the aggregate market.

Five of the highest return companies – FDM Group (FDM), Games Workshop (GAW), IG Group (IGG), Plus500 (PLUS) and Softcat (SCT) – are asset-light businesses, consistent with GMO’s preference. They also have net cash rather than net debt, meaning their balance sheets are robust.

A screen of the FTSE 350 on SharePad using two of Fundsmith’s metrics – high return on capital employed and high gross margins – throws up another interesting list of stocks.

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SHARES’ TOP PICKS

Shares has selected five stocks which have what it takes in terms of business model, margins and returns to protect them from rising input cost inflation, and which look attractive price wise. All five are worth buying for the current environment, so is Fundsmith Equity fund which is profiled at the end of this article.

Howden Joinery (HWDN) 829p

While the pandemic had a significant impact on trading last year, Howden (HWDN) managed to limit the impact on sales to just 2%. It also maintained a 60% gross margin, despite higher costs, by raising prices to its customers.

Once stores were permitted to reopen last June, pent-up demand from the repair, maintenance and improvement market saw sales accelerate 16% in the second half compared with 2019 levels.

That momentum has continued into the current financial year, with UK revenues to April 2021 up 47% on 2020 and 13% on 2019, while the firm’s European store network saw sales up 108% on last year and nearly 38% on 2019 in the first four months.

That has given Howden the confidence to roll out 35 new UK depots this year compared with three last year and 11 new depots in Europe, increasing its network by a third, on top of its refurbishment plans.

Uniquely, Howden appears on three of the tables in this article, ticking every box from return on capital to gross margin, balance sheet strength and a reasonable valuation. (IC)

XP Power (XPP) £55

XP Power (XPP) is a specialist electronics engineer, producing critical power equipment solutions for applications which require custom output voltage combinations, unique control or status signals, and specific mechanical packaging for optimal performance.

Its markets include aerospace and defence, health care and semiconductors, with all sectors seeing healthy demand, especially semiconductor manufacturing. By the end of the first quarter the book to bill ratio was back to 1.29 compared with 0.94 in the final quarter of 2020.

XP’s high level of research and development spending – on average 12% of revenues per year since 2002 – gives it proprietary intellectual property which few peers can match, making customers and revenues sticky.

Last year the firm was able to increase revenues and lift its gross margin to over 47%, which is outstanding for a manufacturing business.

With an estimated 6% market share, the   firm has plenty of potential to grow, and while the shares are close to all-time highs, we see the business continuing to deliver strong results. (SF)

Safestore (SAFE) 947.5p

Shares in Safestore (SAFE) may not be cheap, trading at 1.7 times net asset value, but it is a high-quality business with an excellent track record worth paying up for.

Safestore provides low cost, secure storage space for companies and individuals – with demand in this market outstripping supply.

Self-storage has benefited during the pandemic for several reasons. First, the nature of these sites means it was relatively easy to make them Covid secure.

People have needed to declutter their homes to make space for home working and a boom in the housing market has increased demand from people who are between properties, while on the corporate side the explosion in online retail has driven demand, particularly from smaller operators.

Perhaps the more relevant and long-lasting change is what Numis describes as a shift from ‘just in time’ to ‘just in case’ supply chains. That means even greater demand for storage space.

Safestore has £128 million in unutilised    bank facilities which should support the company’s expansion in the Benelux countries and Spain. (TS)

Games Workshop 

Fantasy miniatures and table-top war games manufacturer and retailer Games Workshop (GAW) is a high-quality business based on several metrics.

For example, the company has achieved an average return on capital employed and return on equity of 55% over the past five years, while the gross margin has averaged close to 70%, according to Stockopedia data.

The reason the company can sustain such high returns are related to the economic advantages that it enjoys, including intellectual property, state of the art manufacturing scale and a large loyal fan base.

Another important characteristic of the business model which is often overlooked is the advantages of vertical integration. The company effectively controls the entire value chain from design, manufacture and distribution, which means it can control costs and set its own prices.

The company distributes directly to its customers via around 529 Warhammer stores, online, and via approximately 6,000 trade partners across the globe.

Arguably Games Workshop has only just scratched the surface of the global revenue opportunity, while its developing royalty business potentially adds more quality to the group. (MG)

Tate & Lyle

Food producer Tate & Lyle (TATE) is a cash generative, progressive dividend payer with a quality tilt.

According to Liberum Capital, the sweeteners-to-ingredients group generates a healthy return on equity of 18%, while results for the year to March 2021 showcased the resilience of the business in the face of the pandemic.

Adjusted pre-tax profit ticked up 6% to £335 million, free cash flow increased by £3 million to £250 million, and Tate & Lyle also sweetened the total dividend by 4.1% to 30.8p.

Return on capital employed remained strong at 17.2%, while the acquisition of stevia and tapioca interests has expanded Tate & Lyle’s customer offering and presence in Asia.

Talks with partners over a potential separation of the higher growth Food and Beverage Solutions unit and its lower growth Primary Products business are ongoing. Break-up talks serve to highlight the value within the group.

Berenberg argues the sale of a controlling stake in Primary Products would lead to a material rerating. On the basis Primary Products is transferred into a joint venture in which Tate & Lyle would have a 40% stake, the investment bank believes ‘new’ Tate & Lyle could be worth as much as 955p per share. (JC)

FUNDSMITH EQUITY FUND  (B41YBW7) 

Fundsmith’s flagship investment fund has generated stellar returns since it launched in November 2010. Since inception to 25 June 2021, the fund has returned 510% versus 250% from the MSCI World index, so more than double the benchmark.

It invests in companies around the world, taking a long-term view rather than trading in and out of stocks seeking a quick return.

Fundsmith favours companies that have these qualities:

• High quality businesses that can sustain a high return on operating capital employed

• Advantages that are difficult to replicate

• No requirement to borrow large amounts of money to generate returns

• A high degree of certainty of growth from reinvestment of cash flows at high rates of return

• Resilient to change, particularly technological innovation

• Attractive valuations

Fundsmith’s portfolio typically has between 20 and 30 stocks, with the biggest holdings currently including Paypal, Microsoft, L’Oréal and Novo Nordisk.

‘The investment philosophy is to buy and hold high-quality businesses that will continually compound in value,’ says analyst Robert Starkey at Morningstar.

‘Fund manager Terry Smith is an original thinker and has often demonstrated his willingness to bet against the crowd.’ (DC)

DISCLAIMER: Daniel Coatsworth and Steven Frazer who contributed to this article both have personal investments in Fundsmith Equity.

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