Much has been written about the impacts of inflation in recent times – together, with its twin nemesis, supply chain disruption – and much theoretical discussion has ensured which overly complicates the matter.

 This is my attempt to simplify the major investment issue we presently face (written mainly to try and get this old noggin around this hydra-headed monster. Appreciate any comments or suggestions here):

 BEWARE companies who are:

(A) Price Takers who have little to no power over the price they must accept from their downstream suppliers (for example those who work with metals where prices are set internationally in response to world-wide supply and demand as dictated by say, The London Metals Exchange. Prices for aluminium have spiked close on 70% over the past twelve months, copper some 16%

Double down your concern if these same price taking companies have no flexibility to pass on the impact of their raw material cost increases.

Indeed, Fixed Price Contractors in all industries must be viewed with suspicion, and at the very least should be critically examined to assess whether they have contractual ability to pass on price escalations. If not, get set to see gross margin squeeze, which may damage one’s investment thesis because the skinnier the margin, the greater the chance of failure, unless there is a strong Balance Sheet to ride out temporary turbulence.   

One such example of this would be Alliance Airlines (AQZ) where they have contractual ability to pass on certain cost increases to their Fly-In-Fly-Out miner customers – fuel cost increases been passed on etc.

I would suggest all investors in mining services companies and companies who have already tendered and won major infrastructure contracts should be examined on abilities to pass on cost increases.

The trauma of fixed price domestic housing is now beginning to rear its ugly head. I am aware of one large home builder offering all people with existing home construction contracts which haven’t been commenced, a return of deposit and an additional $15,000 ‘no questions asked incentive’ to simply rip up the contract, and the take up rate has been huge!

(B) Employers of Scarce Human Resources…surely there cannot be an intelligent investor who is unaware of the massive shortage of both skilled and unskilled resources caused by pent up demand (and changed career choices) post Covid as well as zero immigration since early 2020. There is intense wages pressure in certain industries (particularly mining) which adds to cost structures.

But this issue creates winners and losers. The winners are the employment agencies and those companies charging out staff on a cost-plus basis.

Other winners are those companies who have a brilliant culture and who both recognize & remunerate staff at the correct level. I’d suggest investors should pay closer attention to the attitudes of management towards existing staff, staff departures (and the reasons why, which might be expressed @ websites like glassdoor.com.au)

I don’t think it an overstatement to imply that quality management will retain staff and thus the troublesome and costly impact of getting new staffing will be avoided.

The losers will be companies with little negotiating power and who must accept potentially lower-class candidates, whilst paying an inflationary wage packet and higher administration costs.

(C) Companies rolling out Large Capital-Intensive Programs…at a time of heightened costs. Think large capital-intensive programs like mining development, large infrastructure and the construction industry in general. Particularly those companies who have committed to any cost-plus contracts. It’s very hard to see these been brought on ‘inside budget’ and we all know how damaging cost blow outs can be to the successful commercialization of many projects.

But there will be winners here. Those who have acquired large CAPEX items prior to the inflationary price rises might have a legitimate case to revalue those assets on a replacement basis.

(D) Highly Leveraged Companies

Interest rate rises and inflation are joined at the hip, so get set for interest rates to rise, and so the cost of finance does become a major item, particularly for those who have invested in fixed assets/buildings where the return on investment is barely above the cost of interest and with no clause to increase the revenue stream. Take a highly leveraged REIT which has an escalation clause of a 1% annual increase maximum, yet inflation is raging at 8% and the interest rate kicks up by 300 basis points. At the very least investor distributions will be cut drastically as the REIT tries to bring loans within set covenants.

Of course, this scenario also applies to any highly leveraged company where their return on capital employed (ROCE) is below or close to the higher interest rate.

Speaking of REITS, inflation and interest rate rises are not especially good for capitalization rates which is a key tool in establishing the capital value of an asset and so one might expect to see a capital write off to reflect a lower carrying value of a property or asset. Particularly annoying to the investor who paid a small premium to book value to acquire in the first place.

Warren Buffett’s famous expression comes to mind here - ‘it’s only when the tide goes out that you find out who has been swimming naked.”

WINNING Companies who Benefit from Inflation    

 Obviously, it will be the reverse to the situations mentioned above.

 (A)        Companies who can independently set their own prices

 And the absolute ‘sweet spot’ here would be a monopoly with a sticky product or service where the costs of moving are either non-existent or prohibitive because of costly downtime & long and costly learning curves on the new product/service selected.

 Think SaaS companies here, and one that has great characteristics here is Xero accounting software (XRO), where it has great ability to increase prices and because it is totally ingrained into the complete fabric of its customers’ business, very sticky.

 There are other industries where pricing can be elastic so as to cover inflationary matters - much to the chagrin of most managers – insurance comes to mind, so too does service companies like solicitors and accountants where one needs to remove the ‘seven veils’ to uncover true hourly rate and hours spent on the job – hence that classic ending to most professional fees ‘fees exceeding, but say $X’

 (B)         Cashed Up Companies with an ability to acquire distressed assets  

 I do believe cashed up companies will begin to see opportunities as inflation and higher interest rates play out because the cycle usually sees a lowering in the capital value of assets over time with debt requiring a capitulation on asset holdings.

 My conclusions:

 Given that inflation, higher interest rates and supply chain problems will detrimentally affect the bottom line of many companies, a higher discount rate should be used to determine intrinsic value (IV) and a greater margin of safety (MOS) should be applied to cater for a correct entry point on share investment.  

 Plus, net debt levels should be considered, as well as critically examining the terms of existing debt structures and the securities pledged. A more expensive debt structure requiring more asset security has been a classic wrestling ‘squirrel hold’ for many in the past.

 ROCE too should be examined to see that the company can use surplus funds at a much better return rate that the debt provisions.

 Management examined critically for quality and ability to manage cash allocations, staffing and other ESG matters.