By Hendrik-Jan Boer, senior portfolio manager, Neuberger Berman
Companies with enduring pricing power have the potential to perform well in the current environment.
Stagnant economic growth and rising inflation are two factors that would give most investors pause. And pause they have: Now, in the latest round of corporate earnings releases, we’re seeing the real business impacts of this new environment—and identifying the companies we believe are well poised to navigate it.
When stagflation strikes, companies with true pricing power have tended to perform well. Recent earnings reports are weeding out those that can preserve their profitability by passing on higher operating costs to their customers.
One dependable gauge of pricing power is a high gross margin, which captures the difference between the price at which a company can sell a product and its direct costs such as raw materials and labour to make it. Gross margins can vary dramatically by industry: For example, automakers have to spend a lot on raw steel, as well as chips, electronic devices, wiring and other inputs, to fabricate their vehicles, while software firms mainly need smart coders to build their applications. Over the last 12 months, the average gross margin for an S&P 500 company was approximately 38%, though some companies boast margins of 80% or more.
A second tell-tale sign of pricing power is a strong operating margin. In addition to raw materials, this metric takes into account various operating costs, including marketing and advertising. Companies with healthy operating margins tend to have loyal customers and dominant distribution networks, which keep a lid on marketing outlays relative to revenue.
While inflation has crept up quickly, its effects are already playing out in the numbers. Some companies have been hit hard, but those with true pricing power have managed to protect their margins against the rising costs of materials and labour.
That’s why we are keeping a close eye on companies with enduring competitive moats and familiar products that add value to everyday life and that people just can’t live without—even if they have to pay much higher prices to get them.
When customers say “take my money” in a tough economy, we believe equity investors should pay attention. We are.