Fed speak translation: “Inflation is back, but we’re not sure for how long.”
The Fed chairman’s assessment of increasing prices is corroborated by investor expectations, real-time inflation measures, and company anecdotes. Higher inflation often increases business costs and leads to rising interest rates. All else equal, both trends pressure equity valuations. High-quality businesses are not immune to these factors, but they possess characteristics that can blunt their impact.
The breakeven inflation rate shown in Chart 1 represents a measure of expected inflation derived from yields on 10-year treasury bonds and 10-year treasury inflation-indexed bonds. The value implies what market participants expect inflation to be in the next 10 years.
As shown in the chart, inflation expectations increased rapidly from lows associated with the early stages of the coronavirus pandemic. This gauge is consistent with recent increases in other inflation measures, including the Consumer Price Index3, Producer Price Index4, and Personal Consumption Expenditures5.
Rising prices are also being reported by businesses held by the Jensen Quality Strategies. For example, TJX Companies, Procter & Gamble, and Genuine Parts all noted rising input costs in recent earnings reports. Examples included shipping constraints, wage pressure, and elevated commodity prices. Left unchecked, higher costs can result in lower profit margins and diminished free cash flow.
The Importance of Pricing Power
High-quality businesses possess durable competitive advantages. Among other things, competitive advantages often allow companies more latitude in pricing their goods and services. The ability to raise prices is critical in an inflationary environment, and we are beginning to see evidence of this trend manifest itself in the comments and actions from companies held in the Jensen Quality Strategies.
TJX Companies (TJX) is the largest off-price retailer in the world and benefits from strong negotiating leverage with its suppliers. The company operates a short-cycle inventory procurement model and can modulate the price it is willing to pay for goods based on current cost trends. As a result, the company’s profit margin rapidly rebounded after an initial, pandemic-related demand shock.
Procter & Gamble (PG) is among the world’s leading suppliers of household goods. Demand for their products is relatively inelastic, and brand equity across the company’s product portfolio creates a deep competitive moat. The company recently noted pressure from rising commodity and freight costs, and, as a result, demonstrated its competitive strength by announcing price increases across several product categories.
Genuine Parts (GPC), a supplier of automotive and industrial replacement parts, has repeatedly raised prices over its history when faced with cost pressures, whether they are driven by inputs like labor and raw materials or external factors such as taxes and tariffs. More recently, the company rolled out a new generation of sophisticated pricing models to respond dynamically to changes in input costs and customer demand.
Interest Rates and Equity Valuations
Interest rates are rising in unison with inflation expectations. The resultant pressure on stock prices is twofold, one direct and one more subtle. First, higher rates result in increased borrowing costs thereby diminishing corporate earnings and cash flow. This leads to a consequent reduction in a company’s intrinsic value, particularly for those businesses employing a high degree of financial leverage. Less apparent is the impact of higher interest rates on the discount rates that are used to value equity securities. Rising rates lower equity valuations by depressing the value of future cash flows.
We expect the relationship between interest rates and stock prices will impact valuations for companies held in the Jensen Quality Strategies. However, we are confident that these high-quality stocks will be less negatively impacted by rising rates than those of lower quality companies. High-quality businesses are characterized by robust financial strength and consistent free cash flow that reduce their dependence on debt capital and the consequent negative impact to their earnings from higher borrowing costs.
Likewise, free cash flow consistency is beneficial in a rising rate environment because it dampens the valuation ‘drag’ from increased discount rates, as hypothetically illustrated in Chart 3.
In these hypothetical examples, the ‘Future Growth’ company can be considered a lower quality business, valued on expectations of fast-growing cash flow in later periods which may not materialize. The ‘Steady Growth’ company emulates a higher quality business that generates steady cash flow in each year, albeit at a slower growth rate.
Both hypothetical companies are equally valued using a 10% discount rate. However, their values diverge when interest rates (and therefore discount rates) change. Future Growth’s value is more sensitive to rate changes, rising faster when rates decrease but falling more dramatically when rates rise. This is a function of its dependence on future cash flows for a greater share of its value. In contrast, Steady Growth’s value is less affected by rate changes due to higher, more predictable near-term cash generation.
Competitive advantages, pricing power, and cash flow consistency are hallmarks of high-quality businesses. These attributes do not completely insulate quality companies from inflationary risks, but we believe they can dampen their negative impact relative to other businesses. We continue to monitor the interplay among inflation expectations, cost pressures, interest rates, and stock prices with an eye towards optimizing the Jensen Quality Strategies based on the balance of fundamental business prospects and stock price valuations.
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1 Cox, Jeff, “Fed Chairman Powell says economic reopening could cause inflation to pick up temporarily,” CNBC; March 4, 2021. https://www.cnbc.com/2021/03/04/fed-chairman-powell-says-economic-reopening-could-cause-inflation-to-pick-up-temporarily.html.
2 Federal Reserve Bank of St. Louis, 10-Year Breakeven Inflation Rate [T10YIE], retrieved from FRED; May, 28, 2021. https://fred.stlouisfed.org/series/T10YIE.
3 “12-month percentage change, Consumer Price Index, selected categories,” Graphics for Economic News Releases, U.S. Bureau of Labor Statistics, March 26, 2021. https://www.bls.gov/charts/consumer-price-index/consumer-price-index-by-category-line-chart.htm.
4 “PPI for final demand, 12-month percent change, not seasonally adjusted,” Graphics for Economic News Releases, U.S. Bureau of Labor Statistics; March 26, 2021. https://www.bls.gov/charts/producer-price-index/final-demand-12-month-percent-change.htm
5 Federal Reserve Bank of Dallas, Trimmed Mean PCE Inflation Rate [PCETRIM12M159SFRBDAL], retrieved from FRED, Federal Reserve Bank of St Louis; May 28, 2021. https://fred.stlouisfed.org/series/PCETRIM12M159SFRBDAL.
6 Board of Governors of the Federal Reserve System (US), 10-Year Treasury Constant Maturity Rate [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis; May, 28, 2021. https://fred.stlouisfed.org/series/DGS10.
The information contained in this article is intended to be educational and informational and not used to make investment decisions. The mention of specific securities should not be considered a recommendation by Jensen. The specific securities identified and described above do not represent all of the securities purchased and sold in Jensen’s investment strategies and it should not be assumed that investment in these securities were or will be profitable. There is no assurance that the securities identified remain in Jensen’s investment strategies or that securities sold have not been repurchased.
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