These sectors are navigating inflation the best
Inflation seems the only thing people are talking about in the wake of massive federal spending to float the economy through the pandemic.
The supply chain crisis, causing increases in component and logistics costs, is prompting outlets around the world to ask when it will end, and what investors can do.
Today, we are going to break down the investable market by industry to see which sectors can ride out any short-term inflation the strongest.
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We wrote about how inflation is driven more by supply shocks than the broad-based devaluation of currency in September. The following month, we further wrote about how the healthy credit environment will maintain the economy’s overall strength and prevent an inflationary spiral.
It’s something we see in management earnings calls. Our analyst team uses our proprietary Earnings Call Forensics technology to dissect hundreds of earnings calls each month. The trend is clear: Many management teams are nervous about the optics of how inflation can impact returns, potentially scaring off investors.
In the past few months, companies like McDonald’s (MCD), PepsiCo (PEP), and Procter & Gamble (PG) have been reporting inflationary pressures. But these companies have also reported price increases in response to those input pressures, with no demand drop off.
Looking at pricing power, sectors like Consumer Staples, Communication Services, Information Technology, Consumer Discretionary, and Health Care all have strong pricing power.
Meanwhile, sectors like Energy, Materials, Utilities, and to a lesser extent Industrials, fare much worse. On the surface, it would appear that you should reduce your exposure to stocks in these sectors during inflationary times.
Let’s put that claim to the test by using Uniform Accounting to drill into the capabilities of different companies. An industry’s aggregate ROA is a powerful proxy for pricing power and testing its strength to weather inflationary pressures.
ROA reflects whether a company can differentiate itself from its peers competitively.
In industries with little competitive differentiation, like Utilities and Industrials, companies can only compete on price. That drives down their power to expand margins, eventually leading ROA to stabilize around the cost of capital.
Industries with greater competitive differentiation like Information Technology can attract demand using other facets of their offerings, like their unique capabilities. That adds pricing power and lifts ROA.
Take a look at how Uniform ROA differs by sector.
It is not surprising that Consumer Staples, Communication Services, Information Technology, Consumer Discretionary, and Health Care have significant pricing power and strong ROA. They will be the most resilient to inflationary pressure.
Energy, Materials, and Utilities are lower return businesses, with Energy and Utilities failing to return higher than the cost of capital.
But there is one industry being misconstrued due to as-reported data. Uniform Accounting highlights that Industrials perform better with pricing pressure than investors may realize.
Now that the $1.2 trillion federal infrastructure bill has been signed into law, investors can hold more confidence than ever that a massive cycle of capital expenditure, and infrastructure spending, is around the corner.
That’s one of the reasons why the Industrials sector is looking particularly interesting even in this inflationary environment.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research