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Inflation protection for equities: seven criteria for selection
It is no longer just a catch-line, it has become tangible in many countries: inflation. In the G7 states, it was at 4.1 percent in October – against 0.8 percent the previous year. In Switzerland, inflation amounted to 1.2 percent. Are Swiss equities in portfolios now facing a stress test?
The good news: there are companies that can pass on rising costs to their clients more efficiently than others. This article will help you focus on inflation protection when selecting shares.
Higher prices for raw materials, increasing difficulty in finding appropriate staff and continued delays in supply chains all lead to higher production costs. And that increases pressure on margins for many companies. How to deal with it? While some companies have considerable power when it comes to pricing, others find it a lot more difficult to pass costs on to clients. Shares in companies with “Pricing Power” have the advantage here – and offer better protection with rising inflation.
Big Swiss companies generate the lion’s share of their sales outside Switzerland. Nestlé, for example, only generates around 1.3 percent of sales at home. 1 This means:
Exactly how much influence can a company have on pricing? Just taking a look at the sector on its own is not enough to enable an evaluation of competitiveness and pricing power. In this case, Michael E. Porter‘s industry structure model helps in making an initial evaluation.
The Vontobel Research Team has derived seven important factors for analyzing competitiveness from this model.
What effect do high – or even expanding – margins have? Insight: companies which are highly innovative normally generate higher gross margins because their share of added value is greater.
|One example is Straumann*, a world leader in implantology and dentistry.|
Which companies are able to stay out of price wars? Insight: differences between individual companies arise out of their market position and the market itself. In strongly regulated sectors such as the telecommunications industry, it is more difficult to pass on additional costs.
|An example of a company with a low risk of involvement in price wars is Partners Group*. For the Asset Manager, the bottleneck is not client demand, but opportunities to invest capital for them. Correspondingly, demand is larger than the offering and price pressure is lower.|
Do innovations drive a market? If so, leading companies often benefit from strong demand and do not need to make so many compromises on the price front.
|VAT Group* is a good example. Its high-end solutions for the strongly expanding semi-conductor sector make the company a major power on pricing.|
What makes a strong brand? Insight: often a mix of various factors, e.g., high levels of innovativeness and a strategic brand leadership which gives rise to high levels of client loyalty.
|Good examples are Cartier (part of Richemont*) or various brands belonging to Nestlé*, e.g., Nespresso.|
Does the company offer clients added value in comparison with price? Insight: this often leads to strong client loyalty and, thus, reduced susceptibility to price wars.
|An example is Belimo*, which manufactures equipment for regulating heating, ventilation and air conditioning. This type of product generally has a very low share in the total costs of a building project, but can deliver high added value.|
Must a company accept higher levels of risk in order to generate the same margin as competitors? Insight: this usually reduces pricing power.
|From outside, it is scarcely possible to quantify many risks – they are often only visible at a later date, namely when they turn out to be “too high”. For that reason, we are foregoing citing a concrete example here; the margin for discretion is considerable.|
Is there a strong concentration of power within the industry? Insight: in the technology sector, the so-called “winner takes it all” effect can be regularly observed. In other words, one company tops another and is subsequently able to maintain its pricing power. Typically, these are companies with platform models or knowledge-based business models.
The low interest rate environment over the last years has led to high liquidity on the financial markets. One consequence had been high levels of activity in mergers and acquisitions (consolidations, spin-offs and take-overs). This enabled the market leaders in the technology sector to further expand their strong position. Sector concentration is often measured in terms of the HHI (Herfinddahl-Hirschman Index). It can facilitate detection of market concentrations and the strength of (price) competition.
|Temenos*, the leading provider of banking software, is one example of a company in an advantageous market position.|
1 Annual Review 2020, Page 49, retrieved 10.11.2021 at
* The companies listed in this article emphasize how the seven-point model supports analysis of industries and individual stocks. They are examples arising out of research results and are not investment ideas or recommendations.
Today, investors’ goals and the world’s need for action—the big picture—are clearer than ever. However, when you get into the details, complexity increases.
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