Finding Pricing Power to Fight Inflation

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Colum McKinley

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Colum McKinley, senior portfolio manager, CIBC Asset Management.

We have seen a real change in the economic environment over the last number of quarters. And what was originally thought to be transitory inflation has become more persistent. And to battle inflation, central banks have started increasing rates. So we’re now in an environment of rising interest rates and rising inflation. Now, increasing interest rates does have the effect, and this is the desired effect from central banks, of slowing the economy. So we’ve seen the Bank of Canada raise rates, we’ve seen the Federal Reserve increase interest rates, and other central banks around the world have joined into a similar path.

And so ultimately, this will reverse some of the stimulus that has been in the economy that has supported us through the COVID environment and take some of that medicine away from the patient. And the result is slower economic growth. Now, what will be really unique and interesting to watch through this cycle is this all happening during a period of exceptionally low levels of unemployment and a high level of desire by, on behalf of consumers, to get out and spend after being locked in our own houses through COVID. And so this is creating significant changes for businesses, and it creates uncertainty for investors, and that creates volatility in the marketplace, and ultimately leads us to opportunities. In any market, there are opportunities that investors can take advantage of.

In an inflationary environment, we think it is very important to look for companies that have pricing power. That they have the ability to reprice their products on an ongoing basis to pass through cost inputs in their business and who remain profitable. And I think a great example of that in the Canadian marketplace are the railroad companies. So both CP and CN Rail. They are fixed cost businesses. They have very strong pricing power. So they’ve been increasing prices, not just in the recent period, but over the last 10 years, they’ve taken consistent price increases.

And one of the reasons they’re able to do that is they have incredibly strong franchises. That the physical footprint of their business, think of it as a giant P across North America, allows them to touch businesses across the country and across the North American economy and continue to push price increases through as they improve service and delivery times for customers. And so we think both of these businesses are going to be able to defend their profitability in an inflationary environment.

And railroad companies are incredibly profitable businesses. Both these companies generate net margins that are well in excess of the average company. So net margins of 25% to 30%, fully taxed. And so that is an incredible level of profitability. In an environment where companies are foreseeing price increases that could challenge their profitability, these are companies that will be able to pass that through, but also are starting from an exceptionally high level of profitability. So they will continue to generate strong cash flow through this cycle. So I think that both the rails are well positioned to continue to prosper in the coming economic period.

In this environment of rising rates and inflation, it creates a lot of uncertainty in the marketplace, and as a result, we see overreactions to individual stocks. And I think a great example of that, that we’ve taken advantage of in our portfolios is Magna. Magna is an auto parts manufacturer. They have seen their stock pressured from a number of factors, including supply chain problems around the world, the war in Ukraine disrupted production in Europe. A number of factors that we think ultimately will prove transitory.

And this is an exceptionally well managed company, and has very low levels of debt on their balance sheet. They’re a technological leader, so when auto companies look for a supplier that can help design the best products, Magna is one of their go-to suppliers. So we think the stock is incredibly mispriced. And one that we want to take advantage of volatility in the marketplace, today’s environment has created that in Magna and we see strong returns over the coming years.