Takeaway: Pricing power and low capital intensity are two keys to sustaining success in an inflationary environment.
While inflation is virtually non-existent in the U.S., there are many countries that today do have significant inflation (i.e Argentina and Brazil). One day, the U.S. will likely face another period of high inflation, as the country did in the late 1970s and early 1980s.
So what types of companies do best in those types of environments?
1. Firms with pricing power
If inflation is running 5% per year and a company’s costs are thus increasing, a company that has pricing power can offset that headwind. If the company can raise prices by 5% per year, without consumers buying less of the company’s products, the company will have effectively passed on the inflation to its customers – and its profits will be protected.
2. Firms with low capital intensity
If a company spends 2% of its revenue on computer servers, even if the costs of computer servers double in 10 years (which would happen if inflation is 7% per year) and revenues don’t change at all (the firm has no pricing power), the firm would then have 4% of its revenue devoted to capital expenditures. That would be a cost headwind, but it would probably not be debilitating. Contrast that scenario with a heavy manufacturer of trucks that spends 10% of its revenue on capital expenditures. In 10 years all else equal, those capital expenditures will now eat up 20% of revenue – a very major headwind to the firm’s cash flows and profits.
While inflation makes things difficult for all businesses, firms with pricing power and firms with low capital intensity should fare better relative to firms that have minimal pricing power and high capital intensity.
A classic text on this for further reading is Warren Buffett’s 1977 piece “How Inflation Swindles the Equity Investor“.