Inflation: taking a measured view
- High inflation can disproportionately affect the stock prices of growth companies in the short term
- This is because some investors focus on how price rises affect their predictions of future cash flows
- But the market doesn’t appreciate the resilience of some firms to price rises or their growth potential
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Baillie Gifford does not have a ‘house view’ on inflation – our investment strategies have the autonomy to form distinct views and to take different approaches regarding each fund’s portfolio.
But in recent times, it’s a topic that’s been on our minds.
Prices have been rising at rates not seen since the early 1980s. War in Ukraine and sanctions against Russia have cut trade routes and played havoc with global supply chains and energy security. But the war is just the latest in a series of extraordinary inflationary circumstances, including:
- An extended period of quantitative easing in the wake of the great financial crisis
- Increased geopolitical competition, which has undermined old assumptions about global trade
- Governments spending vast amounts of money to counter Covid-19’s economic shock
- An unbalancing of supply and demand and interruption to trade caused by the global pandemic
Energy, food, labour, packaging and transport costs are all affected.
For example, in the UK, the cost of motor fuels was more than 43 per cent higher in July 2022 than 12 months before, while a pint of milk was 40 per cent more costly and a pack of salmon fillets 23 per cent more expensive.
Baillie Gifford’s Risk Team is working closely with our investment manager colleagues to analyse how inflation affects companies’ fundamental functions. We invest in many kinds of businesses on behalf of our clients, so our approach is not uniform.
For companies that are more affected by macroeconomic adversity, we are looking closely at their resilience, solvency and likely future recovery.
We’re also scrutinising consumer staples companies with low margins, whose revenue growth rate may be stuck in single digits. These include firms making food, clothes and other everyday goods. Through this analysis, we’re framing new questions for ourselves and our holdings’ management teams.
Our research shows that inflation mainly hits portfolios by increasing discount rates. This is the interest rate used to value, today, the forecast of future cash flows (in simple terms, the amount of money flowing in and out of a company). That’s how markets usually price in inflation expectations when valuing a business or a portfolio.
We have also looked at:
- How capital intensive the companies in our portfolios are – how much they spend on factories, research and other expensive requirements
- The relationship between their capital expenditure and their profitability
- The speed of their business cycles – how quickly they move between periods of differing growth
- Their ability to generate cash and reinvest it
- How much they depend on capital spending to keep growth going or just to stay in business
Interestingly, though academic studies disagree on the links between inflation and equity returns, they show that a rising discount rate disproportionately hits the stock prices of companies where the emphasis is on cash flows growing further into the future. These include many of the types of businesses Baillie Gifford invests in.
To be clear, there’s nothing intrinsic to how these growth companies operate that makes them especially vulnerable to inflation or any other macroeconomic factor for that matter. Instead, it’s their long-growth timeline that affects their valuation today. Because inflation eats into expectations of future returns, the market likes stocks presently earning higher returns after taxes and inflation. It also likes those that can depend on cash coming in right now and have resilient margins and proven profitability.
Naturally, these stocks are favoured by many investors at the expense of those that are longer-term, less certain, and more about future growth potential.
Taking the long view
We’ve learned that when considering what inflation might mean to future cash flows, markets can’t readily grasp how the fundamental strengths of a business might still make a positive difference.
Our analysis hasn’t given us a grand universal theory about the link between inflation and equity returns (this remains a hot topic of debate for both academics and practitioners). Still, it has helped identify and quantify the facets of a company that we think matter. They include the:
- Ratio of capital spending to performance and profitability
- Size of margins
- Speed of the business cycle
- Ratio of revenues to working capital – ie how effectively a company generates cash
Measuring and comparing these aspects gives our investment teams a fresh perspective on individual firms’ growth cases.
It also provides a means to assess the inflation resilience of our portfolio companies. The four most important factors we focus on to achieve this are:
- Pricing power – the ability to raise prices and keep customers
- Sales growth
- Operational leverage – the ability to turn extra sales into extra profits
- Sensitivity to interest rate rises
What does that tell us? That the kinds of disruptive and innovative companies we invest in, while not impervious, tend to have underlying strengths that reduce their vulnerability to inflationary forces in the long term, providing they can be fundamentally resilient. This gives us confidence that they retain growth potential.
They may, however, experience volatility and drawdowns over the short- to medium-term that can be uncomfortable. So our investment managers focus on signal versus noise over long-term time horizons. And they place a forward-looking emphasis on businesses where they believe there is superior growth potential.
As mentioned before, Baillie Gifford’s investment strategies have differing views on inflation, among other matters. But this is how four of our funds map the key resilience factors to specific stocks:
US Equity Growth Fund: pricing power
NVIDIA , San Jose, California, USA
By Ben James, Director, US Equities Team
Graphic processing units (GPUs) are essential to many technologies. These include video games, artificial intelligence analysis and the high-performance computing required for scientific research, as well as emerging areas such as augmented and virtual reality, self-driving vehicles and robotics.
NVIDIA’s position as the leading designer of GPUs puts the company in a prime position to continue to stay ahead of competition, despite the challenging macroeconomic environment. Despite logistics disruptions and chip shortages, NVIDIA has been able to increase profit margins in recent years and has a proven ability to pass extra input costs on to customers.
Two factors account for this impressive pricing power: first, NVIDIA controls more than three-quarters of the market and its GPUs are considered the best in the business. Secondly, graphic cards have a limited shelf life. Users need to update their units regularly to benefit from constant performance improvements. These factors have contributed to success that looks set to continue over the long term as the company keeps on innovating and expanding into new markets.
EAFE Plus All Cap Fund: operational leverage
Mettler Toledo, Zürich, Switzerland
By Andrew Daynes, Client Service Manager, Clients Department
Operational leverage means high fixed production costs but low costs for additional units of production. In other words, a company can sell more units without markedly increasing production costs. The more it sells, the more profitable it becomes.
Swiss company Mettler Toledo makes weighing and measuring equipment for industrial and laboratory use. It has consistently grown earnings per share at about 15 per cent a year made up of 5 per cent revenue growth, 5 per cent margin increases and 5 per cent share buybacks.
It operates in a niche where customers’ priority is accuracy of measurement. Price is secondary. It also has an excellent sales force and has become extremely efficient at selling products containing only incremental innovations.
This all means that in inflationary times the company has options: it’s in a strong position to pass on extra costs, but it also has headroom to cut margins, take market share and steal a march on its rivals that will benefit it in the long term.
International Growth Fund: interest rate sensitivity
HDFC, Mumbai, India
By Joe Faraday, Director, International Equities Team
Indian financial services giant HDFC benefits from positive interest rate sensitivity. This means that when rates go up, which tends to happen in response to high inflation, they directly benefit the company.
The firm is the largest mortgage provider in India, with businesses in life insurance, asset management and banking. It’s a trusted brand in a fast-growing market, with an extensive network of branches as well as good digital platforms.
As interest rates rise, HDFC’s net interest rate – the difference between what the company pays in interest on deposits and what it charges on loans – increases, so it becomes more profitable. What matters more, however, is how it uses these extra profits and how it copes when interest rates are low.
HDFC takes a conservative, long-term view. The company is very good at reinvesting profits to drive long-term growth. This cautious approach means that when rates do drop, the company can still build for its future and cushion itself further against the threat of future failure.
Emerging Markets ex China Fund: sales growth
SEA Ltd, Singapore
By Tim Erskine-Murray, Director, Emerging Markets Team
Selling new kinds of products and services whose disruptive appeal defies short-term trends and cycles is good protection against inflation.
Take Singapore’s SEA Ltd. From success with the video game Free Fire (averaging more than 290 million players per month), it has aggressively expanded into ecommerce with its Shopee brand and built up its digital payments and financial services arm, SeaMoney.
The group, which operates in Southeast Asia and Taiwan, generated $2.9bn of revenue in the second quarter of 2022, up 29 per cent from the previous year. The long-term picture is encouraging: gaming is predicted to grow from a $175bn market to a $300bn market by 2025, and SEA has about 2 per cent cent of the global market.
More than $19bn of sales were made on Shopee’s site over the three months, 27 per cent more than the same period a year earlier. But ecommerce penetration is still only 12 per cent in Southeast Asia and is expected to grow to over 20 per cent in the next few years.
SeaMoney could be an even larger opportunity than ecommerce, with 74 per cent of its addressable markets either unbanked or underbanked. Rival fintech companies don’t have the ecommerce data on which a lending and payments business is best built.
The Funds are distributed by Baillie Gifford Funds Services LLC. Baillie Gifford Funds Services LLC is registered as a broker-dealer with the SEC, a member of FINRA and is an affiliate of Baillie Gifford Overseas Limited. All information is sourced from Baillie Gifford & Co unless otherwise stated.
As with all mutual funds, the value of an investment in the Fund could decline, so you could lose money. International investing involves special risks, which include changes in currency rates, foreign taxation and differences in auditing standards and securities regulations, political uncertainty and greater volatility. These risks are even greater when investing in emerging markets. Security prices in emerging markets can be significantly more volatile than in the more developed nations of the world, reflecting the greater uncertainties of investing in less established markets and economies. Currency risk includes the risk that the foreign currencies in which a Fund’s investments are traded, in which a Fund receives income, or in which a Fund has taken a position, will decline in value relative to the U.S. dollar. Hedging against a decline in the value of currency does not eliminate fluctuations in the prices of portfolio securities or prevent losses if the prices of such securities decline. In addition, hedging a foreign currency can have a negative effect on performance if the U.S. dollar declines in value relative to that currency, or if the currency hedging is otherwise ineffective.
For more information about these and other risks of an investment in the Funds, see "Principal Investment Risks" and "Additional Investment Strategies" in the prospectus. There can be no assurance that the Funds will achieve their investment objectives.
The images used in this article are for illustrative purposes only.
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