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From beverage manufacturers to luxury goods: How pricing power trumps inflation

However, the last few months have presented investors, and companies, with a new set of challenges stemming from the invasion of Ukraine and China’s zero-Covid policy.

This is feeding into rampant and more persistent inflation, a more aggressive US Federal Reserve, rising bond yields and worries about slowing global growth. These factors paint a worsening outlook for the pace of corporate earnings growth in the second half of 2022.

Over the last two years, we have seen a disconnect between the economy and the stock market. Stocks have done well, the S&P 500 was up 27% in 2021, yet the valuation on a price-to-earnings basis was slightly down.

How is that possible? Stellar earnings that surprised on the upside by about 30%. In an environment of rising yields, this puts greater pressure on valuations – particularly those with longer duration cashflows, as we have seen with many growth and technology companies.

As such, valuations will matter more than they have in recent years and a focus on profit margins will be critical to navigate changing leadership in equities.

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While earnings growth is coming in lower than previous quarters given tougher base effects and softer activity, the Q1 earnings season is off to a pretty good start, so far.  At the time of writing, over 40% of S&P 500 companies have reported so far, 79% are beating profit expectations, and surprising positively by 6% in aggregate.

At a sector level earnings delivery has been mixed, with commodity sectors seeing the most significant upward revisions. Top-line growth is coming in at double digits and while revenue growth is healthy, slower earnings suggest margins may have peaked.

Cost pressures remain in focus given rising wages and input prices, consistent with recent quarters, but corporates have been largely successful at passing on higher expenses to customers. As a result, profit margins have been holding up.

However, companies that have benefitted from pricing power in a supply-constrained, inflationary environment could be challenged if they can no longer push price hikes to consumers.

Furthermore, after showing some signs of improvement earlier this year, the backdrop for supply chain disruptions has once again turned challenging over the past few weeks due to the combination of the ongoing war in Ukraine and the spread of the Omicron variant amid China’s zero-Covid policy.

Inflation will remain a key risk and is essentially a tax on capital. This raises the bar for return on capital, but all not all companies are created equal; therefore inflation will filter out weaker and non-productive companies. Those with clear pricing power, who can protect margins by continuing to pass costs to consumers, can maintain or even grow earnings.

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Luxury goods is an area that has surprisingly been resilient in crises, having only had six pullbacks in the last 20 years. Strong brands that are hard to replicate are able to increase pricing and pass this to customers. Furthermore, the typical luxury goods consumer is unlikely to be heavily impacted by higher food and energy prices directly – these represent a small part of their expenditures.

While there is a correlation between global GDP growth, and demand for luxury goods and notwithstanding worries of a looming recession on the horizon – consumer balance sheets are in a strong position and leverage is remarkably low.

Investors also remain thirsty for leading brands within beverages. The industry tends to be dominated by a few players with strong brand recognition. Coca Cola, for example, enjoys a favourable runway from reopening dynamics and incremental price increase actions, which should drive positive earnings revisions. In the current environment, Coke is one of the more defensive staples because of its asset light model, high gross margin structure, and lower inflation exposure.

Within financials, exchanges have a monopoly-like structure, with high barriers to entry, strong free cash flows and the ability to expand margins. They also tend to benefit in an environment of elevated volatility given higher trading volumes.

As reopening continues and the world starts to live with covid, areas such as travel, and aerospace also provide compelling opportunities. There is a lot of pent-up demand with room to cater for price agnostic travelers.

With slowing growth, elevated inflation and a plethora of uncertainties, the road ahead may seem a daunting for investors. Consumers will continue to feel the pinch of rising prices and input costs will likely remain higher for companies than the market has currently priced in. We are focusing on those companies that can continue to improve economic returns with the durability of margins – for those who have pricing power – it could be the antidote to inflation.

Ritu Vohora is an investment specialist at T. Rowe Price

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