The importance of operating margin during inflation

Low margin businesses lose competitiveness during inflation

One of our main arguments when we published our mega caps equity theme basket was that during inflation mega caps would do better than the average because of their market power, brand recognition, wider and cheaper distribution, and access to cheaper capital. As we described in several equity notes inflation hits consumers and industries very differently, but one things is the same for all, the cost of capital goes up increasing the hurdle rate for businesses in creating shareholder value. Warren Buffett was very aware of this phenomenon during the 1970s and the experience of inflation led him and Charlie Munger down the road of finding businesses with strong moats.

The initial wave of inflation was easy for most companies because the excess stimulus meant that businesses could easily pass on their rising costs with little negative impact on the business. The second wave started late last year culminating in the Fed abandoning its belief that inflation was transitory setting in motion an interest rate shock in the year that followed. The second phase of inflation is not as easy as the first as employees are now requiring compensation for their lost purchasing power adding significant wage pressures in the economy. For low margin businesses this is a worrisome dynamic. The fact that you have a lower margin means that your sensitivity to wage pressures is higher than a competitor with a higher margin or just businesses in the same sector with higher margins.

The market has recognised this dynamic in its valuation. The chart below shows the 10% highest operating margin businesses in the industrials sector across North America and Europe compared to the 10% lowest operating margin businesses since December 2020 when inflation began accelerating. Part of the difference in total return is a repricing due to higher interest rates as the low margin businesses generally had a higher duration (interest rate sensitivity) from higher equity valuations, but the average P/E ratio of the 10% highest margin businesses was 41.5 back in December 2020, so the impact from interest rate sensitivity is most likely minimal.