Inflation is here - should you get worried about your portfolio? Well, owners of average businesses may say yes, simply thinking about the profit, which is what’s left from sales after all costs are deducted. Prevalent inflation pushes up the cost of doing business, and hence, squeezes profit in the end.
To protect our portfolio from cost inflation, we at Hillside tend to overweight capital-light and labor-light business models. For instance, Singapore-based street snacks outlet operator Snack Empire (HKSE:01843, Financial) employs a franchise model to expand outside of its home market – that is essentially using others’ capital to open new stores.
Now, take a look at this formula again: Profit = Sales – Cost.
You may have noticed that another way to alleviate inflationary pressure could be an increase in sales without a material impact on cost – that is, to sell the same items but sell them at a higher price. Unfortunately, not many businesses can enjoy strong pricing power, in our opinion. But we capture a few in our portfolio, including Microsoft (MSFT, Financial), which decided to raise the price of its Office products by 15% to 20% last year.
Here comes the next question – how big of a price increase would be sufficient to fully compensate business owners for lost profit due to cost inflation? The answer may not be as straightforward as you expect. The key factor here is profit margin. The formula for this is: Profit Margin = (Sales – Cost) / Sales
Here is an example. We estimate the average operating (profit) margin for the S&P 500 to be around 15%, while Hillside Co. (basically, a hypothetical entity representing the weighted average of companies in our equity portfolio) has an operating margin of over 30%. Let’s say both S&P 500 and Hillside Co. have sales of $100 this year; the former would incur a total cost of $85 and generate a profit of $15; the latter a total cost of $70 and a profit of $30. Now, inflation is expected to cause a 20% increase in cost for both next year. Here is what would happen theoretically:
| Sales | Cost (after inflation) | Profit (without a price increase) | Price increase needed to bring back profitability | |
| S&P 500 | $100 | $102 | ($2) | $17 or 17% |
| Hillside Co. | $100 | $84 | 16$ | $14 or 14% |
As indicated in the table, higher-margin businesses are less vulnerable to inflation in terms of profitability. Also, they can afford to bring profit back to the pre-inflation level through a smaller price increase.
In a nutshell, low-cost operations, strong pricing power and superior profitability provide protection for shareholder value in the face of high inflation. These are also some of the traits of high-quality companies we exclusively focus on.
This article was written by the author and first appeared in Hillside Wealth Management's monthly newsletter.
