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06 Sep 2021 - High-margin, asset-light businesses are the best defence against inflation
By: Claremont Global

 High-margin, asset-light businesses

are the best defence against inflation  

Bob Desmond, Claremont Global

August 2021

 


With the latest US CPI reading over 5%, we have been receiving a number of questions from investors about what this means for the future composition of our portfolio. Well, the simple answer is not that much ― and here's why.

 

The difficulty with economic forecasts

As regular readers of our articles will know, we believe that accurate and consistent economic forecasts are exceptionally difficult, and it is even more difficult to successfully construct a portfolio to express such a view.

We received a very good example of this in March as the US 10-year Treasury bond yield moved above 1.70 per cent on stronger economic growth and fears of higher inflation. One view accompanying this move was that now was an opportune time to sell "growth" businesses and buy their "value" counterparts.

The narrative was that growth companies will suffer disproportionately as the market attaches a higher discount rate to their future profits - which are longer duration than their more cyclical value counterparts. In addition, more cyclical companies can expect to see a recovery in their profitability due to stronger economic growth.

At a basic level, you can edit the "sell growth, buy value" argument to "sell technology, buy financials". In June we wrote an article where our advice was - and continues to be - don't sell great businesses based on an uncertain economic forecast!

And once again, recent events have turned out to be somewhat different than consensus expectations. Bond yields have since retreated to 1.2% ― which when combined with some exceptional "big tech" earnings over the last two quarters has seen a strong rally in many of their share prices.

 

Another quarter of big tech earnings growth

To illustrate this, let's take our portfolio's two technology companies - Alphabet and Microsoft - which saw their revenue rise by 62% and 21% respectively, an astonishing result for companies of their size.

Admittedly Alphabet was up against an easy comparison last year, as COVID-19 cut advertising revenue ― however, even on a two-year basis revenue is still up by 26% a year. In contrast, JP Morgan - one of the world's most respected banks - saw their revenue fall by 8% year-over-year.

It just makes no business sense for us to sell some of the world's most competitively advantaged businesses, pay capital gains tax and then reinvest in slower growing, more cyclical businesses based on a macro prediction ― which may or may not be correct. 

Or, even if we look at the events of the last 18 months - an authority no less than the Reserve Bank forecasted that the Australian economy would shrink by 20% as a result of COVID-19, whilst the reality is an economy that is actually larger than pre-pandemic.

But to the point of this article … let's assume that the macro forecasters are correct and inflation rises materially in coming years. What type of businesses would you want to own?

 

Lessons from Zimbabwe

I do have some experience in this regard, having spent the early part of my career in Zimbabwe under hyperinflationary conditions. While this is an obviously extreme case, it's still worth trying to draw some lessons from that experience.

Intuitively, one's immediate response (and one you often see in the media) is to "buy assets". However, my experience was that the best businesses to own in inflationary periods are asset-light ones, and more obviously those with pricing power and high margins.

As inflation rises, so do the capital demands of the business you own. This includes the capital that needs to be invested in working capital and fixed assets, with the inevitable impact that has on free cash flow.

In Zimbabwe, it was not uncommon to see companies report exceptional profits, as inventory and depreciation was expensed through the income statement at much lower historical prices. In contrast, free cash flow was far lower than profit, as new inventory and fixed assets are replaced at much higher prices.

Warren Buffett described this aptly when writing about inflation in the 1970s:

"Inflation acts as a gigantic corporate tapeworm. That tapeworm pre-emptively consumes its requisite daily diet of investment dollars, regardless of the health of the host organism. Regardless of a company's profits, it must spend more on receivables, inventory, and fixed assets to simply equal the unit volume of the previous year. 

Asset-heavy businesses with meagre returns on equity "have no leftovers" to spend on expanding, paying down debt, issuing dividends, or making acquisitions. Spending cash in those areas could mean sacrificing sales volumes, long-term competitive position, or financial strength. The tapeworm of inflation simply cleans the plate."

In our companies, two key metrics we focus on are gross margin and capital expenditure to sales.

Companies that have a high gross margin are often blessed with a low cost/high-value ratio from a client perspective. This means they are a very small part of a customer's cost but are essential to running that business and have few substitutes.

Microsoft provides immense value relative to the cost

A clear example in our portfolio is Microsoft. What company can afford to turn their subscription off to save on costs and how much cost would they really save anyway? The monthly subscription to Office 365 is only $29 a month for an enterprise customer. There is an immense value provided relative to the cost. The worst business to own is one that has:

  • low gross margins, 
  • is asset-intensive, 
  • is a large part of a customer's expenses, 
  • is one where there are plenty of substitute products with low switching costs.

The first thing a CFO is going to do when costs are rising, is look at the list of the largest suppliers and ask them to reduce costs ― just at a time when those suppliers own costs are rising. Good luck trying to ask Microsoft to reduce prices!

The combination of limited pricing power and asset intensity can be particularly pernicious. A business cannot raise prices in line with inflation, whilst simultaneously its own capital needs are accelerating as the "tapeworm" of inflation requires more dollars to be spent just to maintain unit volume and its capital base.

If things get bad enough, free cash flow turns materially negative. And in this scenario, the company takes on debt (at ever-higher interest rates as inflation rises) or is forced to issue equity at depressed prices ― resulting in permanent value destruction.

 

Allocate your capital as a CEO would

Across our portfolio, the weighted gross margin is 55% and this compares to 35% for the S&P 500, which demonstrates the competitive advantage and the inherent pricing power of our businesses.

Our capital expenditure to sales ratio is 5% versus the market at 7.9%. As such, our businesses have a collective gross margin that is more than 57% higher than the market, with capital expenditure needs that are 37% lower.

It makes no business sense to us to sell some of the best businesses in the world to buy slower growing, lower margin and more cyclical businesses on the basis that inflation is just around the corner. After all, which CEO do you know who would sell the highest margin, most asset-light, cash generative, competitively advantaged divisions to reinvest capital in the lower margin, capital intensive ones on a view that higher inflation is on the way?

To quote Warren Buffett again:

"I am a better investor because I am a businessman; I am a better businessman because I am an investor. Investing is most intelligent when it is most businesslike".

 

High conviction investing

Claremont Global is a high conviction portfolio of value-creating businesses at reasonable prices. 


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