Valuing Growth

In these inflation-ridden times, companies with strong brands selling things people need to buy should be resilient.

| 7 min read

Companies with market power can pass on the extra costs they incur as raw materials, energy, and components go up in price. They can recoup the same margin on a turnover puffed up by inflation.

Companies producing goods and services that people may have to do without as budgets are squeezed will find it more difficult as demand slackens off. Companies that produce basics but are in very competitive markets will also struggle to recoup their higher outgoings. Some companies will temporarily produce better profits from stock gains. If they have items in stock produced when costs are lower, they can sell them at the enhanced prices inflation has delivered. These may be one off profits. They also have to face the extra financing costs of replacing the sold stock at the much higher prices for energy and raw materials that now apply. It is necessary for the investment analyst to look at both how sustainable the margins are, and at the cash requirements higher inflation brings. It is particularly important to check enough of the profit is reflected in cash generation. This is a good market for careful share selection.

They will not necessarily rise and fall together.

There is another hazard for investors which we have seen in this week’s disappointing price movements. Even companies with great brands, strong market positions, and some growth may still be affected by rising interest rates. As Central Banks tighten and drive the price of bonds down and yields up, so share markets may adjust their valuations of good companies to reflect the new higher running returns becoming available as the price of other assets falls. Microsoft produced figures showing revenue growth of 18% and operating profit growth of 19% after a great year the year before. These were impressive for a year of recovery in other sectors as lockdowns reduced. Alphabet, the corporate vehicle for Google services, delivered 23% revenue growth though net income and earnings per share fell, owing to some losses on shares. YouTube growth was disappointing but overall, the turnover progress was good. In both cases, the markets first responded poorly to the figures, looking for weaknesses within them and ignoring the obvious growth prospects of big parts of these businesses.

Apple pleased the market despite reporting continuing supply chain difficulties. Demand remained good and the brand still has strong appeal. Amazon disappointed when it revealed a loss. Turnover growth had slowed and the costs of its rapid build-up of more extensive customer service and delivery has an impact on margins. These very large companies have an impact on the overall US and world indices given their large market valuations.

Far worse this year has happened to Tesla. The stellar performer of last year with markets star struck by Elon Musk, the founder, and by the prospects for electric vehicles has seen a 27% fall in share price so far in 2022. The fall has been most pronounced in recent days. Markets seem worried by Mr Musk’s growing interest in Twitter. They are concerned that he might need to sell more Tesla shares to fund that venture, and it might take too much of his time and energy. Where Alphabet and Microsoft, Apple, and Amazon are vast businesses with huge turnover underpinning their share valuations, Tesla raced to $1 trillion of value based on exciting estimates of just how many electric cars it will be producing in due course. It is true Tesla has proved early critics wrong. It did produce 305,000 vehicles in the first quarter and grew revenues 81% over the last year to $18.7bn. It is true they could well expand quickly from here. It is also true that with cars selling for prices over $44,000 and many considerably dearer than that they are not a mass market product. It is still an open question which companies will design and sell the iconic Mini or Golf of the electric car trade to dominate volume tables.

In these more difficult markets sceptics can have their way some of the time.

This week has seen a whole series of worries come together. Some were most concerned about the persistence of inflation. Gone are the Central Banks intoning that the inflation is transitory and no worry, as they chase to tighten money and credit to stop the inflation spreading and lasting. The outriders in the bad news stakes were Spanish producer price inflation - at 46% over the last year - and US house prices continuing to chalk up an annual rise, close to a fifth. The better news was some further weakness in the oil price from recent highs as China’s lockdowns affects demand. Inflation should come down in the second half of the year in the many countries that have now tightened money and indicated a concern about price rises. The very high prices of energy and some commodities will be in the historic prices, bringing down the rate of future inflation.

Some were concerned about the continuing war in Ukraine. Russia announced an end to sales of gas to Poland and Bulgaria, forcing them to seek gas from neighbours or from the international markets. Germany remains the large importer of Russian gas and German policy, as articulated by Chancellor Scholz, remains careful about Russia as he is keen to avoid the loss of gas supplies. The west is keener to get Russia out of its supply chains for oil than for gas and this move will continue to place some strains on energy markets. It also looks likely that the dreadful war will drag on with more deaths and property damage on a large scale.

Some were worried about the state of the Chinese economy. The world’s second largest economy and the dominant exporting manufacturer of the world has been hit again by a flare up in virus cases and by its strict lockdown policies. This means more disruption to damaged supply chains. The US GDP figures for the first quarter showing a fall were partly distorted by a surge in imports to restock and to keep up with strong consumer demand.

These worries are not new, and some have resolutions in sight. China produced a package of measures this week to try to ease the squeeze and stabilise financial markets there. Most of the large US digital corporations reporting demonstrated that they can still grow revenues as most countries come out of lockdown. The inflation we are now seeing must be closer to the peaks, as counter measures start to kick in in a range of advanced countries that have put up interest rates and stopped money creation.

Investors need to be looking for the companies and sectors that can do well in these more difficult conditions.

We are watching for longer-term signs that the authorities will win their battle against inflation and will reach peak interest rates in good time as part of that battle.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Valuing Growth

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