Thread by @vitaliyk

Inflation will benefit some companies, be indifferent to others, and hurt the rest. To understand what separates winners from losers, we need to understand the physics of how inflation flows through a company’s income statement and balance sheet.

THREAD

Let’s start with revenue. Higher prices across the economy are a main feature of inflation. We want to own companies that have pricing power.

Pricing power is the ability to raise prices without suffering a decline in revenue that comes from customers’ inability to afford higher prices or from the loss of customers to competitors.

Companies that have strong brands, monopolies, or products that represent a very small portion of customer budgets usually have pricing power.

If Apple raises prices on the iPhone, you’ll curse Steve Jobs and pay the higher price. (A friend of mine curses him every time the iPhone frustrates him. I keep reminding him that Steve is no longer with us. Doesn’t help.)

Of course, if Apple raises iPhone prices too much and its products become unaffordable, consumers may just start buying iThings less often.

Tobacco companies have pricing power. I lived through a hyperinflation in Russia in the late 1980s and early 1990s, I was a smoker then. One day cigarette prices doubled — price shock! I cursed at tobacco companies; my smokes didn’t get any cheaper. Then prices doubled again.

Smokers are very loyal to their brands, and cigarettes are an addictive product. We own plenty of these stocks, too. The same applies to beer and especially hard liquor.

What the pandemic showed us is that humans are adaptable creatures – you throw adversity at us, we’ll indulge in angry outbursts but we’ll adapt. The rate of change of inflation matters even more than absolute rate of inflation.

If inflation remains predictable, even at a higher level, then businesses will plan for and price it into their products. If the rate of growth is highly variable, then there is going to be a war of pricing powers for shrinking purchasing ability of the end customer.

We want to own companies that are on the winning side of that war.

Let’s go to the expenses side of the income statement. Companies whose expenses are impacted the least by rising prices do well, too. Generally, companies with larger fixed costs do better.

But. It is important to differentiate whether the capital intensity of a business lies in the past or in the future. A business whose high capital intensity is in the past benefits from inflation. Think of a pipeline company, for instance (we own plenty of those).

Most of its costs are fixed, and they have been incurred in yesterday’s pre-inflation dollars. The cost of maintaining pipelines will go up, but in relation to the total cost of constructing pipelines these costs are small.

However, companies that operate pipelines have debt-heavy balance sheets, which can become a source of higher costs. Pipeline companies we own have debt maturities that go out many decades into the future. They’ll be paying off these debts with inflated cash flows.

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