10 stocks that could protect investors from inflation

Lots of companies could struggle if high inflation is here to stay, but Stockopedia’s Ben Hobson has a way of picking possible winners whatever happens. Here are some of his best ideas.  

Inflation became an increasingly important theme in the stock market during 2021. After more than 20 years of uneventful economic conditions, upward pressure on prices turned more and more heads.

Conventional thinking goes that inflation doesn’t really cause too many problems for equity investors. If you’re holding cash, then the power of your pound may fall. But if you’re holding stocks, you’re better placed to benefit from the economic uplift that comes with inflation. But is that really the case?

The idea that the stock market is a hedge for inflation is based on assumptions that may not always hold true. In particular, the idea that companies can simply pass on higher input prices to their customers isn’t straightforward. While some undoubtedly can, many others just don’t have that kind of pricing power.

Any investor reading market news at a time of rising inflation will know how many firms mention “input prices” as a cause for concern. When the cost of raw materials goes up, they have to either absorb those costs or pass them on. And for those that can’t, their profitability is at risk.

Impact of rising prices

For much of the past 25 years, major economies around the world have enjoyed a period of largely stable, low-level inflation. In the UK, rates have generally stayed well within the Bank of England’s target range of 2%. But the figure jumped to 4.6% in 2021, and no one really knows whether it’s a passing phase or something more serious.

In terms of the impact on shares, research (by the investment company Schroders) shows that market returns tend to be best when rates are relatively low and rising. Returns are worst when rates are high (at greater than 3%) and rising. A big part of the problem is the disruption that inflation causes to revenues and earnings as companies find ways of absorbing it.

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While inflation may not be a major priority right now, it’s worth considering the financial traits in companies that might better protect them from inflation disruption. One of the most important is pricing power.

Pricing power is what quality-focused investors look for in “economic moats”. Being able to control prices can be a major competitive advantage but it’s also desirable when input costs are rising. It can manifest itself in companies for all sorts of reasons. It might be that a business has a particularly faithful customer base (or customers who have little option but to use it). It could be that the products are highly desirable (fashion, high-end tech), essential (pharmaceuticals), addictive (tobacco) or just scarce.

Appeal of strong margins

Over the years, researchers have looked for an optimum way of measuring pricing power. But a simple, useful starting point is to look at a company’s Operating Profit Margin.

Operating margin is a measure of how much income a company has left after paying all its operating costs, such as rent and staff salaries (but before paying debt interest and taxes). It is calculated by dividing its operating profit by its revenue.

The point of this measure is that it tells you how good the company is at being profitable from its operations. It’s most effective when used to compare companies in the same industries, because they often have similar cost structures.

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Generally, high margins can be a pointer to companies that are efficient at controlling their variable costs. The higher the margin, the less financially vulnerable they may be. And if you can find operating margins that are growing, it can suggest that profitability is improving.

From an inflation perspective, trends in operating margin can be an early indicator of companies that are either benefiting from rising inflation, or starting to see their profitability eroded by it.

Here is a screen that looks for companies with well above average operating margins in their industry sectors, over both the past 12 months and on average over five years. It also uses sales growth rules to ensure that the resulting companies have been growing their revenues in previous years and are forecast to keep growing them in the future.

Navigating periods of inflation growth

Given that central banks and economists struggle to predict and manage inflation, there’s little point in investors trying to do the same. While some inflation can be a benefit to stocks, evidence suggests that periods of persistently high inflation can be problematic for many companies in the end. The telltale signs can be seen as more and more of them raise it as an issue in their earnings reports.​​​​​​​

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For investors, it's worth keeping in mind how these phases can impact different companies. Operating margins can be a useful indicator to watch, because profitability is at risk when companies struggle to pass on rising costs.

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