We are going through a period of high inflation; this is something we have not seen in decades. What are the characteristics of businesses that are more resistant to inflation?
Here is a list of the characteristics:
- Companies that can raise prices
- Low capital intensity
- High Gross Profit margin
Companies that can Raise prices
Companies need to be able to raise prices without suffering a drop in the volume of items they sell. These include brands, products and services that have few substitutes available.
“A brand is a wonderful thing to own during inflation.“
Business that can raise prices include examples like See’s Candies, which Buffett has owned since 1972. Let’s look at See’s performance during the high inflationary period of the 70s.
See’s Candies from 1972 to 1982
In 1972, when Buffett bought over See’s Candies, the revenue of was US$31 million and it sold 17 million pounds of candy. A decade later, in 1982 it sold 24 million pounds, which gives it a compounded annual growth rate of 3.5%. This was decent volume growth for a period where inflation was high. On the other hand, revenue growth was amazing. Over the same period, revenue grew to US$124 million, which was a compounded annual growth rate of 15%*. The average price increase per pound of candy was about 10% per year. This was higher than the average inflation of about 7% in that period.
Price rise from 1982 to 2022
By 1982, See’s was candy at about $5 a pound of candy. Today, a pound of chocolate retails at $30 per pound, this represents a compound annual growth rate of about 4.5%. This is a decent growth rate for a period of significantly lower inflation.
Low Capital Intensity
At 2015’s Berkshire Hathaway shareholder meeting, Warren Buffett was asked
“Which types of businesses are best to own during periods of high inflation?”
Buffett: “Businesses that do not require reinvestment of capital are good“
In other words, the best business to own is one that doesn’t require continuous reinvestment or huge capital investments. During periods of high inflation, the reinvestment becomes more expensive. Berkshire has not put in new capital into See’s candies since investing in it. He said in his 1994 annual letter:
“We would love to increase our economic interest in See’s……, but we haven’t found a way to add to a 100% holding.”
High Gross Profit Margin
Terry Smith of Fundsmith, explained the importance of high margins during periods of high inflation
“Inflation causes an increase in the cost of the ingredients, components and other inputs which constitute companies’ Cost of Goods Sold (‘COGS’). The best defence against this inflation is a high gross margin……………. The effect on COGS is not the only effect of inflation but it is clear that the high and sustainable gross profit margins of our companies provide a robust first line of defence.”
The difference between revenue and cost of goods sold (COGS) is gross profit. The COGS is the direct costs of producing the goods sold by a company. This includes the cost of the materials and labour directly used to create the goods/services.
I have provided an example of Co A a very high gross margin business let’s imagine it’s our favourite chocolate candy company vs Co B in a low margin commodity business.
In this example, In Co A, for every $100 of revenue it cost them $30 to produce the item resulting in a Gross profit margin (GPM) of 70% vs Co B , which has a much lower GPM of 20%. Usually, this is also an indication of high fixed cost vs variable cost too.
Assuming we have an inflation of 10%. The COGS for Co A goes up from $30 to $33 and Co B $80 to $88. But look at the impact on the Gross profit of the two companies from $70 to $67 vs $20 to $12 respectively. We see a much large percentage drop; for Co A it’s a drop of 4.3% vs 40% in Co B. Here we see a clear distinction between the two companies and how a high gross profit margin can better weather inflation.
In times of inflation, companies that raise prices like See’s Candies will be able to better pass on the cost of raw material increase on to their customers. Businesses with low capital intensity will benefit as there is little required to spend during such times. Last but not least, higher GPM will help reduce the impact of inflation on profits.
*Pricing a Box of Candy – Warren Buffett & See’s –