Buffett: How to Find Inflation-Proof Companies

The Oracle has highlighted the qualities investors should look for

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Jan 20, 2022
Summary
  • Rising commodity prices are becoming an issue for investors.
  • Some companies can pass these costs on.
  • Buffett thinks there's one quality investors should look for.
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One of the biggest challenges companies face is rising commodity prices. Commodity prices across the market are surging due to supply and demand imbalances.

The demand for commodities has exploded over the past year as economies have started to open up. There has been a significant shift in consumer spending, away from services towards goods, as stuck-at-home shoppers spend their money on products rather than out-of-home services.

As well as this demand-side factor, there are also supply issues. When the global economy shut down in the first half of 2020, many factories and production facilities also closed.

It took weeks for these facilities to reopen, and when they did, they struggled to match rising demand.

Pressing issues

These factors have only become more pressing over the past 12 months. Throughout 2021, the pressure started to alleviate in some markets as companies worked through order backlogs, but many markets are far from equilibrium. It could be years before demand can increase to match the rising supply.

In some markets, such as oil and gas and shipping, the challenges have only been exacerbated by years of underinvestment. Over the past couple of years, as oil prices have languished, capital spending has fallen by around 75%.

The shipping sector has also been contracting since the financial crisis. Many companies over-ordered heading into the crisis. Those companies that survived the crisis and the subsequent recession were deeply scarred. Since then, the industry has adopted a cautious approach when projecting demand for new vessels.

Investors face a challenge to find companies that can pass these rising costs on to consumers. That is not as easy as it sounds. Not all companies can pass higher prices on to consumers without facing some sort of backlash.

Finding the right companies

This is a topic Charlie Munger (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) discussed in 2005 at the annual Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholder meeting. Responding to a shareholder who asked about the impact of rising commodity prices would have on corporate profit margins, Buffett noted:

"Over time the businesses with strong competitive positions manage to pass through increases in raw material costs, just as they passed through increases in labor costs."

He also noted at the time that corporate America was reporting some of the highest profit margins in history, which provided a high level of flexibility for companies to absorb costs without having to raise prices and potentially put customers off.

Corporate profit margins have only increased since 2005, so, if anything, corporate America is in a stronger position today to shrug off high commodity prices than it was 17 years ago. The one downside of this is that companies may have to make do with lower margins as they absorb the additional cost.

Buffett advised investors there may be "something of a reversion to the mean" on profit margins as corporations absorb rising costs.

Munger also added that it is "hard to know just which companies can pass through the increases in costs that come from higher commodity prices."

Buffett explained one of the strategies to determine which companies can pass higher prices on to consumers is to analyze how they have performed in the past.

He cited the example of See's Candy, which has a history of pushing through small price increases. The company has been able to do this and continually grow its sales, suggesting consumers are still happy to purchase the product at a higher rate.

This is not a failsafe solution for finding businesses that have the potential to navigate an inflationary environment successfully.

However, it does provide a roadmap for investors. Companies that have a history of raising prices and maintaining consumer interest should be able to pass on costs better than others.

Unfortunately, this does not guarantee they will be immune to profit margin compression. This is something investors may have to factor in their growth projections as a result.

Disclosures

I am/ we are currently short the stocks mentioned. Click for the complete disclosure