Quality growth as a shield against inflation

As central banks walk the line between curbing inflation and averting recession, anxious investors should remain focused on quality growth companies, particularly after the valuation compression we had this year

Spiking inflation has been the primary risk impacting markets for most of the past year. Unexpected inflation acts as a silent tax on real returns across all asset classes. Bonds and cash fare especially poorly in times of rising prices. Bond income is fixed in nominal terms and cash loses its purchasing power at the inflation rate. However, inflation is generally less of a concern for quality and growth companies which benefit from pricing power and high gross margins.

When evaluating how inflation impacts equities, there are two primary effects to consider: the effect on the share price and the effect on company fundamentals. Equity valuations have suffered significantly this year, with global markets trading into bear territory as interest rates rise in view of a higher discount rate on future earnings. When it comes to fundamentals, higher quality companies are able to grow their earnings above the inflation rate, unlike most other companies which tend to be price-takers.

The impact on equity prices is more straightforward. Rising rates are usually a headwind for growth shares. Rising inflation brings higher nominal interest rates. These higher discount rates mechanically reduce the present value of future cash flows for all assets. Assets with longer duration growth are penalized more by the higher discount rate. Growth shares derive a greater portion of their value from earnings that will occur many years in the future and are thus more sensitive to changes in interest rates than value shares, which have shorter-duration cash flows.

In short, the effect of rising inflation and interest rates favours value stocks over growth stocks. However, the market is forward-looking. In recent months, the market has already incorporated higher rates into the appraisal of equities. Investors in growth shares may take solace from the fact that most of this repricing is behind us. The solution is not to abandon growth but to mitigate risk through fundamental stock picking. The reasonableness of a growth company’s valuation becomes more important during a period of rising inflation and interest rates.

The second effect of inflation is on company fundamentals. Here the focus is on owning high-quality companies which benefit from pricing power, high gross margins, and sound balance sheets. Pricing power refers to the ability of companies to increase prices without resulting in a fall in demand, given a brand’s appeal to end customers. Economists call this condition low price elasticity of demand and it arises when a company has a strong position relative to competitors and delivers exceptional value to customers. 

High gross margins are closely related to pricing power. A company with high margins has much more of a buffer to handle adversity and rising costs. On the contrary, if a company’s cost of sales is significant and leaves little of the top line left to cover overheads and other operating expenses, it can be difficult to consistently generate a profit.  

Finally, it is not only pricing power that provides a shield against inflation. As rising prices lead to higher interest rates, sound balance sheets can also protect a business. Many quality growth companies have low leverage levels which protect them against the rising risk of debt. This also places them at a competitive advantage versus the market.

As we head into the third quarter reporting season, it will be important to watch for signs of stress on earnings as tight monetary policy impacts the real economy with a lag. Different businesses will weather this chapter in history with varying degree of success. This reinforces the need for selectivity and further argues for a focus on companies with quality to offer a buffer in the case of a slowdown. Following the broad correction we have had so far this year, quality growth companies continue to be priced at a discount to the market, therefore having the potential to outperform as investors looks to enhance portfolio resilience amid the prevailing uncertainty.

Disclaimer: This article is brought to you by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd, which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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