It’s the unwanted guest who refuses to leave…
I’m talking about inflation.
On February 24, the Federal Reserve released its preferred inflation measure, the Personal Consumption Expenditures Index (PCE). It rose by 4.7% in January, up from 4.4% in December.
The Fed has jacked up interest rates 450 basis points over the past 11 months… specifically to tamp down on inflation.
Yet despite all its hawkishness, the Fed can’t evict the scourge of higher prices from the economy.
At the same time, consumer spending continues to rise. January figures rose by 1.1% relative to December… And that was after adjusting for higher prices.
While increased consumer spending pushes the likelihood of a recession farther out into the future… It will force the Fed to raise rates higher than previously indicated and for longer.
Earlier this year, the market was pricing in higher interest rates following January’s exceptional jobs report.
At the time, investors expected the Fed would raise its key interest rate to 5.2%. Since then, it’s risen to 5.4%.
And as we saw over the past week, the fear of rising rates is causing turmoil in the market. The S&P 500 fell by nearly 3% last week, its worst weekly sell-off since the beginning of December.
In this environment, I expect the market to remain volatile. Stocks are experiencing headwinds that may keep a lid on potential gains.
But there is one characteristic that I believe will be key to finding the best bets right now.
The Key to Beating Inflation
Companies are experiencing high costs across the board.
Raw materials like plastic, steel, lumber, and paper are all significantly more expensive than they were before the COVID-19 pandemic.
Commercial mortgage rates for buildings and warehouses are at multiyear highs.
Wages are still growing at a 4.4% annual rate. That’s nearly double the annual 2.3% pace pre-COVID.
Throw in the possibility of a recession… And it’s no surprise the market is in flux right now.
For a company to thrive in these times, they need some level of pricing power.
Pricing power is the ability of a company to pass its costs onto customers. In most cases, customers have no choice but to accept the price hikes.
For example, everyone has to eat and pay for shelter and utilities. Drivers need to put gas in their cars.
In some cases, companies have few competitors. Think of utility companies, such as NextEra Energy, that operate in natural monopolies.
Companies with pricing power can expand their profits. And investors typically reward companies that have this advantage.
Among S&P 500 companies, those that expanded their gross profit margins in 2022 grew their share price by an average of 1.5% over 12 months. That’s compared with an 8.2% overall drop in the index.
Now, this is not a hard and fast rule. There are companies with pricing power that underperformed the index for their own reasons.
However, the ability to grow profit margins can help insulate a company’s share price from the headwinds affecting the broader market. That is especially valuable in the environment we find ourselves in today.
Finding Companies With Pricing Power
The sources of pricing power differ across companies and industries. However, finding companies with this advantage can be simple.
First, look at a company’s gross profit margin. This tells us the percentage of revenue a company keeps after paying all of the costs that go into producing its products or services.
Over the long term, a company with strong pricing power should see its gross margins grow.
While identifying companies with pricing power is simple, they are rare.
Take a look at the table below…
It includes stocks that both expanded gross profit margins in 2022 and had a three-year track record pre-COVID of expanding margins.
I also filtered through the stocks to find those that earn free cash flow, carry relatively low debt, and pay a dividend.
Those characteristics don’t necessarily indicate pricing power. However, they do filter out lower-quality companies.
What we end up with are 11 stocks that are exceptional at flexing their pricing power to grow profits.
It is important to note that no stock screen is the end to a search. Rather, it is the starting point for additional analysis.
By digging further into the dynamics of each company, you can find different types of pricing power.
Medtronic, a medical device manufacturer, uses a shared-risk pricing model that at times reimburses customers for follow-up procedures. This allows it to charge a premium on its equipment that’s difficult for competitors to match.
Roper Technologies is an engineering conglomerate. It can justify higher prices through add-on services it offers each client.
Old Dominion is a freight trucking company. It uses a “one all-in rate” pricing strategy.
This simplifies the pricing process for its clients, which allows Old Dominion to charge a premium to its competitors. Clients are willing to take on these higher rates in exchange for convenience.
Investors who identify companies with strong pricing power can profit even in this inflationary environment.
If I were you, I’d start with the companies in the table above.
As always, do your homework before making any investment. And never invest more than you can afford to lose.
Analyst, Palm Beach Daily