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Pricing power

These are challenging conditions for equity investors. Inflation is everywhere and has dictated the direction of travel for both monetary policy and investor sentiment thus far in 2022.

A medley of supply chain shortages, Russia’s invasion of Ukraine and the far-reaching spectre of Covid-19 have conspired to see inflation figures soar worldwide.

In May, inflation in the United States jumped 8.6%1, marking the nation’s highest rate in four decades. Similar multiples had already been reached in the UK, with mainland Europe also witnessing a steep rise in prices.

The respective central banks have moved to intervene, with the Bank of England and the US Federal Reserve both raising interest rates in response. The European Central Bank followed suit in June by announcing a 25bp hike in July, signalling the end of its super loose monetary policy.

The knock-on effect for equities has been stifling, with companies left to grapple with increased costs and more expensive borrowing, paired with a consumer base whose salary has been cut in real terms (short of any inflation-linked pay structures).

There have been pockets of value to be found in real assets such as property and commodities, but from a stock-picker’s perspective, we have had to review the lens through which we view prospective investments.

One metric which we have prioritised during this period is that of ‘pricing power’, which we believe to be particularly pertinent to the inflationary environment.

What is pricing power?

In broad terms, pricing power may be defined as a company’s ability to raise its prices without losing customers to a competitor.  We view this as a means to offset inflation, with the companies that are able to pass some of their increased costs on to their customers in a stronger position than those that can’t.

To identify companies positioned to benefit from this trend, we analyse how much value a company can provide relative to the cost of the product or service.

Let’s take Amazon Prime UK as an example. The first thing to note is its consumer base, which at circa 15 million subscribers (per a 2021 report by Mintel2) immediately offers a degree of comfort. Prime’s multi-layered offering includes streaming services and next-day delivery from a vast marketplace, for the relatively meagre price of £7.99 a month or £79 for a year.

Faced with no real e-commerce competition, Amazon’s theoretical pricing power is in a strong position, with a consumer base that when squeezed, would still likely deem its services worthwhile.

Perhaps a better example still is that of the Taiwan Semiconductor Manufacturing Company (TSMC), a foundry that produces semiconductors. Over the past decade, these chips have become increasingly commonplace and are used in everything from mobile phones to cars and laptops.

However, these chips are complex, and production can take time. This, in tandem with the pandemic, created a global shortage as supply raced to keep up with the demand from freshly-minted homeworkers. In fact, such was the impact of this shortfall that in 2021, several automotive production lines were shut down due to the lack of semiconductors available.

The competitive environment for semiconductors is quite concentrated, with only a handful of companies manufacturing chips. Whilst demand is now mixed, TSMC is in an advantageous position when it comes to pricing power, perhaps more so than Amazon, as it is selling direct to enterprises as opposed to cash-strapped consumers. Clearly, more individual consumers will be looking to trade down in a bid to stretch their finances further.

In fact, given its clientele (listed multinational companies), the public nature of those enterprises’ assets allow TSMC to determine if its market can withstand a price increase and to what extent.

A key mechanism

The distinction to be made between each company’s consumer base is an important additional overlay we consider when conducting our due diligence.

We are seeking companies whose products are difficult, if not impossible, to replicate, and whose consumer base would continue supporting should prices rise further. When reviewing potential holdings in an inflation-rich environment, pricing power is one of the key mechanisms available to offset such pressures. We therefore believe that pricing power is more important now than at any other stage in the cycle.

 

Important Information

The information contained in this document is provided for use by investment professionals and is not for onward distribution to, or to be relied upon by, retail investors.

No guarantee, warranty or representation (express or implied) is given as to the document’s accuracy or completeness.

The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice.

Canada Life Asset Management is the brand for investment management activities undertaken by Canada Life Asset Management Limited, Canada Life Limited and Canada Life European Real Estate Limited. Canada Life Asset Management Limited (no. 03846821), Canada Life Limited (no.00973271) and Canada Life European Real Estate Limited (no. 03846823) are all registered in England and the registered office for all three entities is Canada Life Place, Potters Bar, Hertfordshire EN6 5BA. Canada Life Asset Management Limited is authorised and regulated by the Financial Conduct Authority. Canada Life Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.

Expiry date 30/06/23

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1 https://www.bloomberg.com/news/articles/2022-06-10/us-inflation-unexpectedly-accelerates-to-40-year-high-of-8-6

2 https://reports.mintel.com/display/1042375/# / https://dontdisappoint.me.uk/resources/technology/amazon-statistics-uk/