This construct bodes well for the continued strong performance of well-managed franchises with strong competitive advantages.
Limited resources versus unlimited wants
As the global economy recovers from the impact of Covid-19, across the world we are seeing a strong resurgence of broad-based demand for new homes, new cars, holidays, consumer durables, takeaway food, OTT entertainment, etc (Source: McKinsey Report: Consumer demand recovery and the lasting effects of COVID-19, 2021). The width and depth of the demand resurgence suggest that the $13 trillion of fiscal and monetary stimuli injected by the OECD countries is playing a significant role in this demand recovery
Unfortunately, this demand resurgence comes at a time when Covid-19 has disrupted a range of supply chains in different parts of the global economy. As a result, we are seeing shortages of everything from semiconductors to shipping containers to truck drivers.
With demand growing faster than supply, in most large economies inflation is rising. In fact, in several countries, including India, we are seeing the strongest CPI prints in 20 years.
CPI inflation in India has now been above 6% for the last 2 consecutive months and it seems unlikely to come down below 6% (which is the upper end of the RBI’s targeted range) anytime soon.
The impact of high inflation on stock prices
In such circumstances, a theory that has been widely propounded is that as interest rates rise to dampen inflationary pressures, stocks with high P/E multiples will come under pressure.
Not only does this theory lack any empirical support (for example, from 2004 to 2008, interest rates were steadily rising – both in the US and in India – and so were the so-called expensive stocks), more rational thinkers have highlighted that high-quality stocks outperform the broader market even more strongly in times of high inflation.
For example, the investment team at the global asset management firm, GMO, found that for the American stock market, over the past hundred years, high-quality stocks outperformed the broader market index in most high inflationary periods.
“…quality stocks have tended to fare well compared to the broader markets in times of rising prices, and that paying attention to valuation alongside quality delivered even better results.”
We conducted a similar exercise for the Indian market using data for the past 21 years and found that high-quality stocks’ outperformance of the Nifty is even stronger when CPI inflation is above 6%.
High-quality companies outperform even more when inflation is high. We define ‘high’ inflation to be months where CPI inflation was above 6% and ‘low’ inflation to be months where CPI inflation was below 4%. ‘Moderate’ inflation is, therefore, the remaining months (when inflation is above 4% but below 6%). Over the last 21 years (starting in July 2000 and ending in May 2021), India has seen 105 months of high inflation, 75 months of moderate inflation and 59 months of low inflation.
As per Marcellus’ investment philosophy, high-quality companies should have clean accounts, rational & effective capital allocation and strong barriers to entry to first thwart and then decimate the competition. We define high-quality stocks to be the 14 names in our Consistent Compounders Portfolio (CCP) and the 12 in our Kings of Capital Portfolio.
Since there is some overlap between these portfolios, the total number of unique names in our high ‘quality’ stock list is 22. Our reasons for deeming these names to be high-quality stocks is as follows:
- These CCP stocks are chosen from a universe of stocks whose market capitalization exceeds Rs 100 crore and which have over the past 10-15 years consistently grown their revenues at 10% or more per annum alongside return on capital employed of 15% or more per annum. The stocks that make it into the CCP portfolio also have to pass our proprietary forensic screens. More details on Marcellus’ approach to forensic accounting.
- The stocks are chosen from a universe of financial services stocks (including banks, NBFCs, insurers, brokers, and asset managers) which over the past 10-15 years have consistently grown their business (loan books or premiums) at more than 15% per annum alongside Return on Equity of more than 15% per annum. To enter our KCP portfolio, these companies must also pass our proprietary accounting screen for lenders.
Having defined quality as the 22 CCP and KCP stocks, we then compared the performance of these stocks versus the Nifty on three counts – PBT margins, revenue growth, and share price returns – across high, moderate and low inflation periods.
As Exhibit 3 (a) shows, unlike in the PBT margin case – where the extent of outperformance for quality stocks vis-à-vis Nifty is the largest when inflation is high (i.e., above 6%) – when it comes to revenue growth, the quality stocks outperformed Nifty companies most during periods of moderate inflation (i.e., between 4% to 6%). However, in case of 3 (b), a similar trend is seen in PBT margins for quality and Nifty can be seen where quality companies’ revenue growth outstrips that of Nifty’s the most (5.5%) during high inflationary periods (when inflation is above 6%), followed by the outperformance (3.6%) in moderate inflationary periods (when inflation is between 4%-6%).
Nonetheless, a key point to note is that in both the scenarios, in times of high inflation, quality companies’ revenue growth significantly outstrips that of Nifty companies. For both, PBT margin and revenue growth, quality companies’ superiority ebb away when inflation is below 4%.
Investment implications
As the four exhibits shown above demonstrate, once CPI inflation crosses 6%, high-quality stocks increase the extent of their outperformance vis-à-vis Nifty stocks in terms of revenue growth, profit margins and, consequently, share price outperformance. Why does this happen?
The answer lies in sustainable competitive advantages. A small minority of franchises in the Indian market (no more than 30 listed companies our research team says) have been able to erect barriers to entry so high that their competitors are constantly on the defensive even in normal economic circumstances.
These barriers to entry can be around the innovative use of technology or they can be around the creation of unique business processes that competitors can’t emulate. The result of these barriers to entry is that quality companies operate with significantly higher profit margins and significantly higher pricing power than their run-of-the-mill competitors.
So, when inflation shoots up and consumers start tightening their belts, a quality company is in a much stronger position to defend its market share (and thus deliver stronger revenue growth) and defend its PBT margin.
It is as the famous saying goes, what doesn’t kill you makes you stronger. High inflation hurts weaker franchises and favours better managed companies with strong competitive advantages.
(Nandita Rajhansa also contributed to this article. She is part of the investments team at Marcellus
Investments Managers. )
