Inflation
Inflation headlines have been easy to find in the financial press this year. This topic came into particular focus earlier this year when the U.S. Bureau of Labor Statistics reported that the year-over-year rise in the consumer price index (CPI) for May was 5.0%. This CPI reading was the highest since the 5.4% recorded in August 2008. The core-price index, which excludes more volatile categories like food and energy, registered its largest increase since June 1992. The producer price index (PPI), which measures changes in selling prices for domestic producers of goods and services further up the supply chain, is also on the rise, up 6.6% year-over-year in May.
Figures 1 and 2. U.S. Inflation since 2011
This acceleration in both CPI and PPI is consistent with the data we are collecting during our calls, from our conversations with management teams across industries, and from company reports. Companies are unable to purchase raw materials or hire labor at prices that prevailed before the pandemic. Their response is to manage these rising input costs by increasing prices for their customers. This same acceleration in inflation is occurring in many foreign currencies, as well. Governments across the globe have expanded their money supplies significantly to stimulate economic growth during the pandemic. Now that the world is largely emerging from COVIDrelated restrictions with aggregate demand returning, this additional money is deteriorating the value of the U.S. dollar and many other currencies.
Will this new inflation rate persist, or will it slow again as capital and labor flow into their highest and best uses in a post-pandemic economy? Our experience with complicated econometric models built by experts to predict the answers to such questions makes us doubt how reliably anyone can forecast the acceleration, persistence, or reversal of inflation. This view begs another important question: if inflation is difficult to predict, then how do we manage its potential risks?
As we underwrite new and existing investments, we think carefully about how a variety of inflation regimes may impact earnings. Some of these key considerations manifest through the income statement while we must consider other core issues through the lens of the balance sheet. Our current portfolio companies are well-positioned, regardless of whether current inflation ends up being permanent or transitory, for several key reasons: (1) all have the power to increase prices with or above inflation, allowing them to maintain margins, (2) many serve consumers who are likely to be positively impacted by commodity price increases, (3) their balance sheets are aimed to protect, if not benefit, from rising rates that are typically a knock-on effect of rising inflation, and (4) on balance, they benefit if the U.S. dollar weakens.
Pricing Power is Critical
Businesses with weak pricing power typically experience shrinking profit margins when input costs rise, as they are unable to fully pass on higher costs to customers via price increases. In contrast, our businesses have repeatedly demonstrated pricing power in inflationary environments. For example, Anheuser-Busch InBev (AB InBev) has a multi-decade history of increasing prices ahead of inflation in its home market of Brazil.
Figures 3. AB InBev Demonstrate Pricing Power
For example, Anheuser-Busch InBev (AB InBev) has a multi-decade history of increasing prices ahead of inflation in its home market of Brazil.
Figure 4. Global Food Prices Have Risen Sharply in 2021
In almost every market in the world, food prices have been rising faster than CPI. Our beverage businesses have participated in this trend, as they have been raising prices ahead of inflation in the last year. If food price increases continue to exceed general inflation, our beverage businesses should expand margins. The Fund’s Coca-Cola bottlers have done just that in the last year.
Like most companies and as would be expected given the inflation data above, our businesses are experiencing increases in their costs, particularly for commodity inputs. Compared to many other consumer product categories, however, raw materials make up a low percentage of the value of ready-to-drink beverages. For example, raw material costs (sweetener, packaging, etc.) are only 13% of total sales for the publicly-traded U.S. bottler Coca-Cola Consolidated and about 21% of sales globally for Heineken. These figures compare favorably to a more commoditized product like cookies where raw material costs (packaging, oils, grains, etc.) are 50%+ of sales. This beneficial cost structure is magnified by the fact that in almost every category our businesses sell the “A brand” product. While their total input costs are like those of “B brand” competitors, our companies can demand a higher price from customers and thus enjoy better margins. For example, in 2020, Arca Continental’s business in Mexico operated at a 25% EBITDA margin versus 13% for the national Pepsi bottler. As input costs are a smaller percentage of profits for “A brand” products, any input cost inflation will have a proportionally greater negative impact on “B brand” profits.
Higher Commodity Prices Help Our Consumers
On the customer demand side of this equation, much of our companies’ profits are earned in countries that are significant exporters of commodities. Commodity price increases lead directly and indirectly to greater incomes for our companies’ customers. For example, copper mining is the biggest industry in Chile and Peru, and the price of copper has recently risen to alltime highs. This jump in copper revenue increases GDP, employment, wage levels, foreign investment, and government tax receipts, all of which eventually put more money in consumers’ pockets. In turn, this spending power is used to buy more of our companies’ products, which are generally modestly priced staples that consumers enjoy daily.
Balance Sheet Strength Matters
Companies with poorly structured balance sheets or significant, ongoing funding needs suffer in an inflationary environment. Increases in inflation are typically accompanied by rising interest rates, which can lead to financial distress for those companies without secure funding. However, each of our businesses generate robust free cash flow5 and most have low leverage and, in some cases, substantial net cash balances. These businesses can take advantage of any distress caused by higher interest rates, including investing heavily to exploit competitive disruptions triggered by macroeconomic stress. For example, we anticipate that Arca Continental could take advantage of a rising interest rate environment to acquire bottling assets that they can improve meaningfully at reasonable prices. Berkshire Hathaway could benefit from rising rates through higher yields on its bond portfolio and through its preferred position as a white knight investor in times of distress.
AB InBev has substantial leverage on its balance sheet, but we believe an inflationary environment would surprisingly create a lot of value for the business because of its attractive debt profile. AB InBev’s debt has an average duration of 16 years, an average coupon of 4% (96% of it at a fixed rate), and no financial covenants. Without an urgent need to refinance this debt, AB InBev could effectively see its real (after inflation) cost of borrowing fall below zero in a world with structurally higher inflation. This development would effectively add tens of billions of dollars to the intrinsic value of the company.
Liberty Latin America is the one business whose balance sheet could be adversely impacted by a jump in inflation. Given its debt load and leverage, its balance sheet is well-structured. The company has no major debt maturities before 2027, an average debt maturity of 7 years, and an average interest rate of 5%. It has also financed its debt in silos, such that distress in one of its subsidiaries would be contained and would not contaminate the other operating divisions. As a collection of local monopolies selling a musthave, utility-like product with rapidly growing consumer demand, the cable business has repeatedly demonstrated strong pricing power around the world. In an extreme scenario, management could quickly pause growth capital expenditures to meet its debt maturities.
A Weakening U.S. Dollar as a Tailwind
Higher U.S. inflation should be a net negative for the U.S. dollar. In fact, the U.S. dollar has weakened materially since mid-2020, which has been a tailwind for the businesses in our portfolio. Since they earn most of their profits in currencies other than the U.S. dollar, these profits become more valuable to us on a U.S. dollar basis as their home currencies strengthen versus the dollar. Additionally, since many raw materials are denominated in U.S. dollars in global markets, a weaker U.S. dollar reduces input costs and boosts margins for many of our companies.
The Superiority of Equities, Especially at Attractive Valuations
To be clear, we do not feign to know if the current elevated inflation rate will accelerate or moderate. Thanks to their current competitive positioning and based on their realized historical operating performance, our businesses should do well regardless of the rate of inflation. Our businesses trade at a wide discount to their intrinsic values. Meanwhile, the total market value of U.S. equities is at an unprecedented level of more than 200% of GDP. The MSCI ACWI currently trades at a 2021 price-to-earnings ratio of 19 times, which is a 50% premium to the Fund’s 2021 price-to-earnings ratio of 13 times. As we have explored in depth in past letters, our businesses’ superior competitive advantages are highlighted by higher margins versus the average business in the MSCI ACWI. We also anticipate our companies to grow earnings faster over the next decade. This more attractive absolute valuation level and better growth profile should position our portfolio well even if market multiples compress due to rising rates.
Figure 5. The Superiority of Equities for the Long-Term Investor
Cash and bonds are terrible investments in an inflationary environment. Alternatively, an investor can buy a ten-year Treasury Inflation-Protected Security (a fixed-income instrument issued by the U.S. government whose principal increases/decreases based on changes in CPI readings) at a yield of 0.8% per year. A negative TIPS yield means that an investor must pay for the ability to protect principal against potential inflation. On the other hand, we think the Fund’s underlying businesses, which in aggregate currently offer a positive 8% earnings yield, could provide a similar long-term mitigant to the deleterious effects of inflation because of their ability to grow these earnings on a nominal and real basis. As noted in Jeremy Siegel’s excellent book Stocks for the Long Run,
In contrast to the returns of fixed-income assets, the historical evidence is overwhelming that the returns on stocks over long time periods have kept pace with inflation. Since stocks are claims on the earnings of real assets – assets whose value is intrinsically related to the price of the goods and services they produce – [it is possible] that their long-term returns will not be harmed by inflation. For example, the period since World War II has been the most inflationary period in [American] history and yet the real returns on stocks have matched that of the previous 150 years. The ability of an asset such as stocks to maintain its purchasing power during periods of inflation makes equities an inflation hedge.
No financial asset, however, is a perfect short-term hedge for inflation.[2] Since 1950, the price-to-earnings multiple of U.S. equity markets has been significantly negatively correlated with absolute U.S. inflation rates. Several theories try to elegantly explain the market’s past behavior, including the impact of higher inflation on discount rates, the unequal distribution of pricing power across companies, the lack of inflation benefits in the U.S. corporate tax code, and the U.S.’s policy of taxing nominal capital gains. All of these theories have some merit, but inflation’s impact on discount rates and the yield curve are the most important.
We expect, and history strongly suggests, nominal interest rates will rise if U.S. inflation stays at elevated levels. A rising risk-free interest rate would drive up the discount rates that investors use to value all types of financial assets. The longer it takes for a financial asset to return its purchase price to an investor through cash flows (i.e., the higher the duration of the financial asset), the greater the impact a change in the discount rate will have on its valuation. A large increase in nominal interest rates will have a modest effect on the quoted price of a five-year treasury note, but the same increase will have a large impact on the price of a thirty-year zero-coupon bond[3]. For example, assuming a five-percentage point upward shift in today’s yield curve, the price of a five-year treasury note would fall while the price of a thirty-year zero-coupon bond would likely decline by substantially more[4]. This illustration is helpful in thinking about the duration of cash flow expectations for equity valuations. Implicit in the valuation of every company is its position on this yield curve. Companies that investors expect to return all of their capital soon in the form of dividends belong on the short end of the yield curve. Our investment in Peruvian brewer Backus, with its 8% dividend yield, is a good example of a stock that has a shorter duration and belongs on this shorter end of the curve. The most speculative of venture capital companies that do not expect to turn a profit for years – and do not expect to pay a dividend for decades – should be valued at the longer end of the curve. In a rising interest rate environment, many high growth companies whose valuations are largely based on the potential return of cash in the distant future will likely behave like the principal payment on a thirty-year zero-coupon bond. On the other hand, cash-generating, high-yielding, and lower-duration assets like the businesses held by the Fund should be less negatively impacted.
Figure 6. Current, Upward-Sloping Yield Curve
Source: Bloomberg; as of 11/2/21
In Conclusion
Inflation is present, and it is difficult to predict whether the recent jump in price levels will be permanent or transitory. Importantly, the businesses in the Fund’s portfolio are well positioned for either outcome. Collectively, they have the power to increase prices with or above inflation, allowing them to maintain margins, and they benefit further if the U.S. dollar weakens. They serve consumers who are likely to be positively impacted by commodity price increases, and their healthy balance sheets are structured to be isolated from or even potentially benefit from increasing interest rates that typically result from rising inflation. These businesses are generating cash at steady and attractive clips, which could provide both us and their management teams interesting investment opportunities if interest rates rise in earnest for the first time in decades.
[1] Stocks for the Long Run, Jeremy Siegel. His evidence does show that since 1872 stocks outperform cash and bonds over 1-year holding periods in very low, low, medium, high, and very high inflation scenarios. See pages 220-222 of the Fifth Edition for the complete argument.
[2] Stocks for the Long Run, Jeremy Siegel. His evidence does show that since 1872 stocks outperform cash and bonds over 1-year holding periods in very low, low, medium, high, and very high inflation scenarios. See pages 220-222 of the Fifth Edition for the complete argument.
[3] Thirty-year zero-coupon bonds are Treasury bonds that do not pay interest and are redeemed at full face value upon maturity (in this case, 30 years). These bonds are purchased at discounts to their face values.
[4] The price of these securities is determined by discounting the expected semi-annual coupons and final principal payment by the risk-free rate implied by the current and hypothetical upward-shifted yield curve.