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Inflation changes my shopping habits but not my investing strategy

Inflation, inflation, inflation.

 

This word might grab the news headlines until you realise that it has an impact on your wallet. I personally felt that my groceries and utilities costs were getting more expensive!

 

But beyond that, the concept of inflation affects us as investors.

 

When there is inflation, companies face increased costs for materials and labour. These are all part of the costs of goods sold. If they can’t pass these costs on to consumers, their profit margins will take a hit.

 

With inflation comes higher interest rates. I am sure that you have heard enough about the FED rising rates. However, this means that companies will find it costly to borrow money.

 

This increased cost of borrowing can limit a company’s ability to expand or invest in new projects, hindering future growth.

 

FED looking stressed after hearing about the inflation results and looking to increase the interest rates.

 

From the consumer's perspective, inflation reduces purchasing power. I will be selective about what to spend knowing that the cost of living is getting expensive. This can result in decreased sales for companies.

 

Recognizing that these factors affect the company's bottom line which in turn impacts our investments, how can we then protect our portfolio against inflation?

 

The obvious answer: find companies that have the potential to outpace inflation. So, what are these companies?

 

Companies with pricing power. And that is the company's ability to raise prices without reducing demand. These companies are typically leaders in their sectors, with strong brands or unique products.

 

Diving deeper, I found six traits that can contribute to a company's pricing power.

 

First, a powerful brand can command higher prices because customers have a strong preference for that brand over others. Take brands like Rolex or Louis Vuitton for example. Customers are willing to pay a premium for luxury items and are less sensitive to price increases.

 

Companies like Rolex are holding its pricing power despite of the persistently strong inflation.
Source: Luxury Bazaar

Then we have companies that offer unique products which are difficult to replicate. Pharmaceutical companies with patented drugs, such as Pfizer, can price their drugs without immediate generic competition.

 

Companies that operate in industries with few competitors also have strong pricing power. They can increase prices without losing market share.

 

The fourth trait to raise pricing power indirectly is to lower per-unit costs. Large companies can scale production, lowering per-unit costs to increase profit margins.

 

Next is to find companies that offer products or services that are costly or inconvenient for customers to switch. We term this high switching cost companies.

 

For example, Adobe software is deeply embedded in the design profession and switching to an alternative may encounter resistance.

 

This gives the company the power to raise prices without significant loss of customers.

 

The last trait is the network effect. As more users join a network, the service becomes more valuable. Companies like Visa benefit from the network effect, allowing them to monetize their platforms effectively, including raising prices on transaction fees.

 

Of course, finding companies with these traits is not enough to protect your portfolio against inflation. You need to diversify too.

 

You need to spread your investments across various asset classes because they respond to inflation differently.

 

Sectors like technology might suffer under inflation while others like consumer staples may fare better. Real estate or REITs are also considered a strong hedge against inflation.

 

In the end, while inflation affects my shopping habits, it doesn't necessarily prevail in determining my investment gains.

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