Quality Investing – Defence Against Inflation

This article is an educational piece about Quality Investing. For informational purposes only.

While there are reasons to be optimistic about a robust recovery, the Covid-19 situation has caused an overwhelming increase in demand of goods and services created by fiscal and social spending by governments all over the world. Unequivocally, the supply-side has had trouble keeping up. This imbalance has resulted in increasing input costs  such as labour, oil, natural gas, copper, coal, steel and lumber, which in turn leads to inflation.

To put the current inflation environment into perspective, Figure 1 shows the US (World’s largest consumer nation) Personal Consumption Expenditure (PCE) inflation and China (World’s largest producer nation) Producer Price Index (PPI) inflation from 3 January 2006 to 31 December 2021. The chart below shows that the latest US PCE and China PPI inflation as of December 2021 were at (or near) its highest at 7.0% and 10.3% respectively.

Figure 1. US CPI, y/y (LHS) vs. China PPI, y/y (RHS), %

Source: Bloomberg

Why should investors be concerned with inflation?

There are three main reasons investors should be concerned with inflation, especially when it is persistently high. Firstly, inflation erodes the profits made on their investments. Say if you make 3% on an investment, but inflation is also at 3%, your real return is zero, and worse, if you don’t make any return on your money. Secondly, inflation erodes purchasing power – the same amount of money cannot buy you the same quantity of goods and services today as it could yesterday. Lastly, rising inflation could increase the cost of raw materials which may rise faster than the company’s ability to raise prices of their products. Coupled with the loss in purchasing power of consumers, demand for products and services could wane. As a result of this double whammy (rising cost and loss of consumers’ purchasing power), these companies experience a decline in earnings which ultimately has a detrimental impact on its stock prices.

Navigating inflationary period with high-quality companies

So, what are quality companies and why are they less affected by inflationary pressures? While there is no standard definition to identifying high-quality companies, after looking at numerous companies’ financial statements and their performances during inflationary periods, I have observed that high-quality companies share some common traits, namely: high return on equity (ROE), better pricing power and low financial leverage.

Allow me to further expound on how these three traits can help investors such as yourself select the best wealth solutions to navigate the current inflationary periods.

–  High return on equity (ROE) – ROE is a measure of a company’s earnings compared with the stockholders’ equity required to run the business. High-quality companies tend to exhibit higher ROE. This means that they are more adept at squeezing returns out of their net assets. When inflation kicks in and stockholders demand for higher returns as compensation (against inflation), high-ROE companies fare better as there is a larger buffer between the earnings potential and the stockholders’ required returns.

–  Pricing power – The biggest impact of rising inflation faced by businesses are increased input costs. As a result, some companies would experience decline in earnings because they are unable to pass on the costs to consumers. High-quality companies are less affected as they can pass on costs directly to their customers by raising the prices of their products and services. Hence, their profit margins remain largely stable and therefore maintaining stable earnings variability. Perhaps it is worth highlighting that “pricing power” is a key differentiator as to why high-quality companies can weather inflation so much better.

– Low financial leverage – High inflation has almost always led to rate hikes. Higher rates result in increased borrowing costs thereby diminishing corporate earnings and cash flows. This leads to a consequent reduction in a company’s intrinsic value, particularly for businesses employing high degrees of financial leverage. High-quality companies have low levels of debt relative to equity. They are less affected by increasing borrowing costs in a rising interest rate environment caused by inflation.

Statistical Evidence

Now that I’ve addressed what high-quality companies are and how they might help investors navigate through inflation, let’s look at current and historical figures to see if it supports the narrative above. After all, numbers speak louder than words!  Extending historical annual data by more than 30 years, Figure 2 shows the annual performance comparison of MSCI World Quality Net Total Return USD Index vs MSCI World Net Total Return USD Index. The figures demonstrate that although the outperformance of both indices had been erratic, what is certain is that during calendar years of 1989, 1990, 1991, 2008 as well as 2021, periods when US was experiencing heightened inflation (i.e. US CPI rate above 3.5%), high-quality companies outperformed the broader MSCI World Index.

Figure 2. MSCI World Quality Net Total Return USD Index vs. MSCI World Net Total Return USD Index

Source: Bloomberg

Final Thoughts

No one can be certain how the evolution of the pandemic would or could impact markets.  Will we see a hot economy with high growth and inflation? Or a slower growth environment with the threat of inflation lurking in the shadows? While many are taking bets and choosing sides, high-quality companies have the potential to outperform in both scenarios. For a long-term investor, we believe it is worth considering quality-investing as a core portfolio allocation.

Even if the current economic inflation proved to be a transitory rather than a persistent phenomenon lasting numerous years, an investor with a high exposure to high-quality  companies will have less to worry.

About the writer:

Kelvin started his career as an Equity Analyst before moving on to advisory roles for both retail and institutional portfolios. With a strong background in technical analysis, Kelvin sees Fibonacci lines, Elliot Waves and chart patterns above his bed, à la Beth Harmon in the Queen’s Gambit. He also enjoys culinary movies, such as “Chef” and “Julie & Julia”, as they delve into the neuroticism of ideas and end in the satisfaction of creating something beautiful, put together with simple, unassuming ingredients, somewhat like working out an investment portfolio. When he’s not obsessing about the financial markets, Kelvin appreciates quality time with friends and family over a game of darts.