Gregory Milano is founder and CEO of Fortuna Advisors LLC and author of Curing Corporate Short-Termism, Future Growth vs. Current Earnings.
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During a bull market, when the economy is growing and stock prices are rising, the rising tide is said to lift all boats. If we continue with the boating aphorism, when the tide falls, boats can falter and sometimes run aground.
Businesses are facing increasing challenges and at the top of the list is rising inflation. According to the Labor Statistics Bureauannual inflation for the 12 months to June, based on the consumer price index, was 9.1% – the highest in more than 40 years, although it eased slightly in July.
And nevertheless inflation is hard to predict, it’s also hard to see it diminish given the cycle it creates. Companies are faced with rising input costs and to protect profit margins, they raise their prices. This increases costs for other companies, who in turn their Prices. In combination with the tight labor market and increased staff turnover, price increases motivating companies to retain talent by raising wages, which is like any other inflation cost.
Another related challenge is the rising cost of capital. When inflation was always low, interest rates were also low, as was the cost of equity. But faced with rising inflation, lenders, including banks and corporate bond holders, strive for higher interest rates so they don’t lose ground. As an example, the average yield to maturity 10-year corporate bonds rated BBB by Standard & Poor’s stood at just over 2% at the end of 2020, and was above 5% by mid-2022.
Cost increases affect companies differently. Some companies have significant exposure to energy prices, so with gasoline rising more than 100% they have been hit particularly hard since early 2021. At the other extreme, for example, are wood prices halved since the end of the year, some industries actually helped. I think the rising cost of capital will affect some companies more than others, with the more capital-intensive companies suffering the most.
The ability of companies to raise prices and pass on these higher operating and capital costs to their customers depends on the differentiation of their products and services. I find that those with a superior offer can generally increase prices without losing much or no sales volume. Those with undifferentiated products and services — or worse, those at a disadvantage — may not be able to raise prices enough to overcome rising costs without a significant loss of volume. Just as some boats run aground when the tide goes down, rising costs can sink some businesses. I think this is one of the main reasons for the declining stock market in 2022.
For companies with multiple companies, geographies, brands, and product or service lines, I predict that these forces will affect different parts of the portfolio in different ways. A brand may be very well known, but perhaps not really liked and desired by consumers, so management may find that any attempt to raise prices is followed by a significant loss of market share.
In the same business portfolio, a highly differentiated brand may be able to recoup rising costs from price increases and maintain sustainable profitable growth. Based on my own analysis, although the S&P 500 index fell about 20% in the first half of 2022, there are more than 100 stocks in the index that are rising this year.
Stay afloat during inflation.
These variables make capital allocation, innovation and brand-building marketing more important, but more difficult to navigate than in years past. Gone are the high tides when most business units in a multi-business company would probably earn at least a decent return on new investment.
To stay afloat, you need to develop sharp insights to identify the companies where new investments will create value and those where value will be destroyed. Allocate more resources where you do best and reduce investment in the areas that no longer cut it in the face of such strong headwinds. I believe that now, more than in years past, business leaders should embrace strategic resource allocation (SRA).
As companies navigate these tumultuous waters, masters and management who steer well can perform better and are more likely to be ready for the next upswing.
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