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More inflation, less earnings: why investors shouldn’t skimp on quality

Bruno Paulson: Morgan Stanley portfolio manager

Pioneer of the modernist architecture movement, Ludwig Mies van der Rohe, would’ve loved inflation.

Known for his minimalist design ethos, van der Rohe coined one of the most efficient and resilient quotes of all time with his ‘less is more’ mantra.

And inflation, especially the non-minimalist kind in vogue today, certainly gives consumers more of less, according to Bruno Paulson, London-based portfolio manager for the Morgan Stanley global equities team.

In a recent Morgan Stanley think-piece, Paulson notes many manufacturers react to rising costs by subtly reducing the quantity on offer rather than hiking product prices in a process known as ‘shrinkflation’.

“Shrinkflation is an increasingly common response by companies to inflation — fewer sheets per roll, fewer caplets per bottle, fewer washes per box,” he says in the article. “Brands quietly downsize their products without decreasing prices accordingly, to maintain or boost profits as they try to navigate increases in the cost of materials, labour, energy, packaging and transport, or to maintain market share in the face of stiffer competition for every dollar.”

While shoppers might eventually see through the less-for-the-same trick for tangible products, inflation has seeped through in a perhaps more insidious way into service companies too.

“We’ve moved on from ‘shrinkflation’ to ‘skimpflation’,” Paulson said. “Some companies are skimping on services and blaming Covid.”

For example, he said many hotels may skip daily room-cleaning or customers have to wait longer to be served in restaurants.

As inflation eats away at the quality of daily life for many, investors are also weighing up the impact of price pressures on future company earnings.

To date, many listed companies have managed to increase both earnings and margins in the wake of the COVID-19 crisis, Paulson said, with most sell-side analysts tipping corporate revenue to hold up over the year ahead: 12-month forward-earnings analyst estimates for the MSCI World Index are up 5 per cent over 2022.

“We are sceptical about those earnings forecasts,” he said.

With recessionary fears mounting, Paulson said many of the rosy corporate revenue assumptions will come under pressure.

“Our concern is that even without a recession, the forecast earnings will fail to materialise,” he said. “Lower quality companies might see their temporary [post-COVID] pricing power disappear.”

In fact, as Paulson notes in the Morgan Stanley article, company profit margins have soared to well above-average levels this year, hitting 17 per cent for the MSCI World Index compared to pre-COVID peak of 15 per cent and the 20-year mean of 13.4 per cent.

Yet inflation threatens to quickly shrink those wide margins through the broad effect of rising prices and wages or the efforts of central banks to cool economies.

“Ultimately, there is a bit of a Catch-22 for companies — either wages rise, potentially squeezing corporates’ margins; or they don’t, threatening real wage falls that could hurt consumption and thus corporates’ top-line sales,” the article says.

But some companies are better-placed than others to withstand the looming assault on profitability, Paulson said, highlighting ‘quality’ as the key factor.

“We define quality as companies that can demonstrate consistent high returns and evidence of pricing power and recurring revenue through market cycles,” he said.

In practice, the Morgan Stanley global shares strategy Paulson helps manage boils down to a concentrated portfolio of 40-odd large cap global stocks that lean heavily to the consumer staples, non-pharmaceutical healthcare, ‘mission critical’ IT and payments sectors.

Morgan Stanley partnered with Salt Funds last year to offer the sustainable version of the global shares strategy – that screens out certain sectors – with the NZ portfolio investment entity (PIE) vehicle now holding about $45 million.

During a brief, but highly active, planned tour of the country over August 8-9, Paulson will flesh-out the fund strategy and Morgan Stanley market views to NZ investors.

“We’re looking for companies that can reliably compound returns for investors over the long term,” he said. “That’s what the [broader] stock market is supposed to do… but it doesn’t.”

Paulson, though, is confident that a hand-picked portfolio of high-quality ‘boring compounders’ can still help investors grow rich slowly: less is more.

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