Stocks that have sustainable business models tend to have longer durations compared to lower quality, less sustainable stocks. That is, they sell on higher short-term price earnings ratios, and therefore, more of their expected future free cash flows are further out in the future. All other things being equal, longer duration assets, including stocks, tend to be more sensitive to changes in long-term bond yields and discount rates. However, the duration of a stock as a measure of its share price sensitivity to changes in interest rates is only valid if the nominal growth rates in the future free cash flows do not change by a similar degree to broadly match the change in long-term bond yields and discount rates.
If our views on higher inflation being transitory turn out to be incorrect, then we believe that allocating capital to high quality businesses that have pricing power and high levels of structural growth will help protect against high inflation levels. We believe most of the companies in our portfolios can pass on cost inflation to their customers, thus enabling them to retain their future earnings and cash flows in “real” (inflation-adjusted) terms. The ability of the stocks in our portfolios to maintain the real value of their future earnings should allow them to minimise the negative impacts of higher inflation over the long term.
In addition, extremely high structural growth stocks are in a better position to handle high levels of inflation compared with stocks with a more modest growth rate. Even if we assume these high-quality stocks are not in a position to increase the nominal value of their future free cash flows and thus retain the real value of those free cash flows, the relative impact on the cash flow is lower.
In a relative sense, the higher the nominal structural growth rate for a company, the less the real growth rate declines for any given increase in inflation. A business with a 40% structural growth rate with 10% inflation suffers a 25% decline in real structural growth (compared to a zero-inflation situation). Contrast that with a 20% nominal growth rate company that would suffer a 50% decline in real growth from a move in inflation from 0% to 10%.
Businesses that can sustain high real growth rates typically have the following attributes:
1) strong and sustainable value propositions;
2) innovative cultures that actively improve the features and quality of the existing products and create new products over time;
3) yet to fully monetise the value of their existing product offering; and
4) revenues that are small relative to the size of their total addressable market (“TAM”).
Low quality businesses will suffer the most in a sustained high inflation environment, because many of these businesses will be unable to pass the cost inflation they experience on to their customers. High quality, structural growth companies should perform better in a relative sense than broader equity benchmarks, which are dominated by “old world” businesses. We define old world businesses as those that are no or low growth and/or are being disrupted by a far superior product or service.
Hyperion estimates 79% of the stocks (by index weight) in the Australian S&P/ASX300 Index can be categorised as old world. Outside Australia, 63% of the MSCI World Index and 54% of the U.S. S&P 500 Index have old world characteristics. This means the level of fundamental risk in the main benchmarks globally is high, as they are dominated by low growth businesses that are being disrupted by higher growth, more modern challengers. This disruption is being driven by the stronger value propositions that these modern businesses offer consumers. Over the next decade, we anticipate that there will be significant levels of “creative destruction” as this transition from incumbents to challengers progresses. In this highly competitive environment, it will be difficult for these large, listed businesses to pass on any input cost pressures in the form of higher prices.
Figure 5: Proportion of benchmarks that are “old world”