Inflation is Far From Dead - How to Invest
Learning from the past
Inflation isn’t dead. Considering the upcoming price increases (+10%) for insulation products (amongst other materials) here in Europe, we don’t rule out a new wave of inflationary pressures. Back in 2021, certain rising raw material prices were the early signifiers of broad-based inflation, which accelerated through 2022.
Companies with inherent pricing power, limited cyclicality and proactive capital allocation regardless of the interest rate environment (you’re in big trouble when the FED is dictating your corporate strategy) are precisely what the Compounding Tortoise portfolio is made up of. As you know, we run a concentrated portfolio. We’ll provide more context around our portfolio strategy, must-read articles, upcoming initiatives on our Substack and much more in the first “Quarterly Letter to Members of the CT Community”, set to be published at the end of April.
And whilst history doesn’t repeat itself, it oftentimes rhymes. Looking at our companies, we’d welcome inflation and interest rate volatility. It has made them more resilient: a higher earnings base, very strong cash flow generation (negative working capital requirements) and “free” margin expansion.
Why hasn’t anyone else tried to take those tailwinds away from them? Good question: that’s what called exploiting your moat/deep competitive strengths. Strong ROIC, a proactive capital allocation policy to reward owners (be it growth CAPEX, share repurchases, dividends), cash flow visibility and an industry-leading position in a steadily growing market: that’s all you need. Unsurprisingly, our companies tend to outperform the market during the bad periods. During a bull market, making money is relatively simple: a rising tide lifts all boats.
But when the going gets tough, the tough get going. That’s why we like boring businesses like Linde. They’ve been around for more than a century and although I’m not an industrial engineer, I bet they’ll survive the next 100 years as well. We don’t need to be on the lookout for fancy investments or a stream of a new ideas. Focusing on what we already own and digging deep into every piece of information make us excited.
Our next deep dive is on Autozone (scheduled for next week) which has been a mind-blowing cannibal for several years and decades now. In terms of inflation, CFO Jackson made the following comment: “It has been a little bit of our friend in terms of what we see in terms of retail pricing” (2022). Initially, inflation caused Autozone’s unrecorded LIFO (debit) reserve to flip to a credit balance. With subsequent deflation in freight costs, the LIFO accounting method has now provided a nice year-over-year tailwind to reported gross margin. Still, excluding this year’s and last year’s LIFO impact, gross margins have continued to grow anyway.