Inflation is back. Retail inflation rose to 4.48 percent in October 2021 and is pegged to cross the 6 percent mark in early 2022. And not just in India. As a result, businesses have started facing the heat with prices of crude oil, raw material etc. on the rise.
One way to beat inflation is to invest in ‘quality stocks’. But let us first understand how inflation impacts businesses.
Inflation has a cascading effect on the overall business. To begin with, it leads to an increase in the costs of raw material, production and borrowings, resulting in lower profit margins.
Companies fight inflation in two ways. One, they increase their prices and pass on the burden of increased costs to consumers (even when product demand is flat and capacity is not fully utilized). Look at what companies like Asian Paints, HUL, ITC and Britannia Industries have done. And two, they increase their production volume with minimal additional capital investment, so the price burden can be minimized by way of better utilization of production capacity. Marico is a recent example of this.
In most cases, you’ll notice that quality companies don’t hesitate to play around with their pricing power and increase prices during inflation. That’s because they enjoy a strong goodwill in the market and have a fiercely loyal customer base. Therefore, they face minimal risk of drop in sales volumes.
Nestle: Managing prices in inflationary times
I can’t think of a better example than Nestle India when it comes to exercising pricing power in the market.
Between the period 2003-2013, when India last witnessed raging inflation, Nestle came out unscathed and exceptionally outperformed other stocks in the market.
A study of its sales and profit figures between 2003 and 2013 shows that Nestle was able to maintain stable margins across the entire inflationary period. Above all, the company had negligible debt, and hence was able to emerge even stronger.
Despite inflation touching the 12.30 percent mark in December 2009, Nestle managed to retain its margins by passing on the increased cost to the end consumers.
It is pretty much riding piggyback on pricing power yet again to keep its profit margins intact and has increased the prices of its products from 1-3 percent in 2021 as commodity costs rise.
Nestle India’s stock price increased 10-fold (23.50 percent growth), while the Sensex has risen by only six times (18.29 percent growth). The average inflation during this period was 7.80 percent.
How to recognise ‘Quality Companies’?
There are certain characteristics that distinguish ‘quality companies’ or ‘quality stocks’ from the rest.
Market Leadership: These companies dominate the market share (in terms of total sales) in their sector. Moreover, they tend to outperform competitors on metrics (such as distribution coverage, price, image, perceived value, brand loyalty and profitability) that gauge business success.
For instance, Nestlé India is a dominant player in the Indian consumer food FMCG (fast moving consumer goods) industry and holds one of the top two spots across most product categories in its portfolio. These include its popular brand Maggi, milk products and nutrition, beverages, prepared dishes and cooking aids, chocolate and confectionery and even pet food.
Economic Moat: Quality investors ideally look to invest in companies that consistently generate high ROCE and higher profit margins, and above all, do so consistently over a large period of time. And this is possible only when the company has an edge over competitors in some form, be it low production costs, unbeatable prices, brand value, supremacy of the products on offer by way of patents, trademarks, copyrights etc., as these form the glue that is vital to retain customers in the long run.
Moreover, this moat or competitive edge must be durable for it to reap benefits for investors.
Pricing power: The effect on demand by changing the price of a company’s product is called pricing power. When a ‘quality company’ like Nestle increases the prices of its products, the volumes don’t see a significant drop, given the fact that the brand has loyal customers.
Profitability: This is an obvious one from the perspective of investment. A great stock company is able to generate profits consistently over a period of time.
Here’s a look at Nestle’s net profit for the period 2013-2021 for example.
Earnings Stability: Earnings stability basically indicates that the company has a relatively predictable pattern of earnings. This is one of the most important criteria you must look for to identify quality stocks for investment.
Nestle is one such company whose earnings have been fairly stable over the last five years.
Product Innovation: Quality companies always focus on staying ahead of the pack and hence are not afraid of spending big on R&D and innovation as a means to retain their competitive edge, and hence, their leadership position.
Nestle too has always been a frontrunner in this aspect and is known to launch innovative and game-changing products globally every now and then. Their plant-based meat products and science-based nutritional concept (GRAINSMART balance) for porridge products are some recent examples.
Brand Loyalty: High quality companies always enjoy exceptional brand loyalty. This means that their customers will continue to buy their brand or products regardless of alternatives available, price or convenience.
What should investors do?
If you see all the parameters above, make a note of how Nestle clears the litmus tests on all. It therefore comes as no surprise that it is amongst the best performing stocks of all times, the returns from which defy even the risk of inflation by leveraging its pricing power. No wonder Nestle is continuing to go strong even 155 years after its inception in 1866.
Companies like these are able to not just survive but thrive in the market by playing the game on their own terms…with their eyes clearly set on maximising the value for all stakeholders involved.
So the next time you want to make an investment, you know what kind of stocks to place your bets on!
Disclaimer: The above stock example is just for illustration and is not a recommendation.