How Inflation Or Deflation Would Impact Our Investments

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Includes: F, KO, V
by: Income Surfer

Summary

America has experienced severe periods of Inflation and Deflation over the last 100 years.

Given the intervention of central bankers, the outlook for the global economy is extremely uncertain.

Certain types of business models are better able to navigate varied economic conditions, and we aim to invest in those businesses.

As a long term investor, I think long and hard about the potential outcomes of investments in my portfolio. I believe that each and every one of my long term holdings will be able to not only survive in the years ahead, but prosper also, even as the economic landscape changes. What will the future look like? I don't know, but I take solace in the fact that my long term holdings have business models that will allow them to adapt to the changing times. Today I want to take a look at few different companies, and discuss how they could be affected in the future.

I think questioning outcomes are especially valid currently, given slowing global growth and that global central bankers are in uncharted territory. The range of possible economic outcomes looks as wide as ever. One whole group of economic "experts" are calling for severe deflation as a result of the slowing global economy, while another group of "experts" is gearing up for high rates of inflation as a result of 7 years of extremely low interest rates. Whatever ultimately happens, it will likely differ from the economic conditions we've recently seen. How will the companies in your portfolio handle these changing conditions?

Let's start with deflation. The "big D" inspires even more fear in the hearts of Wall Street bankers, than does that other "D" (divorce). The United States hasn't had a persistent bout of systemic deflation since the 1930s, but that era was a huge deal and shaped the mindset of two whole generations. Central banker's greatest fear is likely runaway deflation. You'll notice the Federal Reserve tries to err on the side of having monetary policy too loose, in an effort to avoid deflation...and reduce the cost of repaying America's national debt. The 1930s saw a tremendous number of businesses close, and high levels of unemployment. Difficult economic conditions for sure.

While that time period was extreme, do you think the companies you invest in would survive significant deflation? I believe some of our long term holdings, like Coca-Cola (NYSE:KO) and Visa (NYSE:V), would weather the storm just fine. Why?! These two companies have remarkable brand recognition, and sizable networks. The brand recognition means that customers will use these companies again and again, all else being equal, and the size of these company's networks means that they have the size and clout to survive. More importantly, each of these companies have exhibited consistently high profit margins and low variable costs. Those high profit margins give the companies flexibility with regard to price flow and how their respective managements choose to allocate cash flow. The low variable input costs, along with the high profit margins, mean that these companies should be able to cut prices and maintain market share...while also remaining profitable. The production plants are already built, so buying a little more (or less) sugar and water won't result in a large capital expenditure decision for a company like Coca-Cola. One big problem with persistent deflation is that some consumers don't spend because they are waiting for lower prices, while other consumers don't spend because they can't afford to as a result of pay cuts or layoffs. A cycle like this becomes a feedback loop, which feeds on itself.

Now let's juxtapose Coca-Cola and Visa, with a company like Ford (NYSE:F). Ford manufactures and sells some wonderful cars and trucks, around the world. Ford's business is highly susceptible to changes in input costs and the spending habits of consumers. A significant bout of deflation would probably reduce consumer demand for Ford's products significantly. Ford's input costs would probably decline some as material (steel, aluminum, plastic) costs would likely decline, but I suspect the company would really struggle on the basis of consumer demand and retail pricing. Ford's management also manages input (like material and labor) costs, by utilizing multi year contracts. These contracts, whether with a steel provider or labor union, don't provide much flexibility for a company like Ford. Ford's management has accepted this approach so that they would not be hit with a significant increase in input costs during times of inflation, but of course the terms of those contracts would cut both ways.

If Ford's management believed a deflationary time would go on for while, they could choose to bring less expensive products to market that may better suit the consumer's changing tastes. Rolling out new products requires expensive changes to the existing factories and may take years to implement. The existing inventory of already constructed products would not be worth much, in such a time, and would likely have to be sold for a loss. If you would like an example of the lack of flexibility that auto manufacturers tolerate, look at the changes they experienced around the 2008/2009 financial crisis. In 2007 and much of 2008, gas prices were soaring and the large SUVs that had been so popular for consumers (and profitable for auto manufacturers) were suddenly not so desirable. So the auto companies came out with new smaller and more fuel efficient vehicles that they hoped consumers would buy, just in time to have the economy turn around...gas prices slashed...and the sales of trucks/SUV climb again a few years later. I don't envy the management of auto manufacturers like Ford. Theirs is a tough industry.

So now let's take a look at the inflation side of things. During times of high inflation, prices rise and spending power declines. As mentioned above, companies like Coca-Cola and Visa have exhibited consistently high profit margins and good brand recognition in the past. During times of high inflation the input costs for most companies would rise, but companies like Coca-Cola and Visa will better be able to pass those higher costs on to customers as a result of their market position and brand power. Both are recognized brands, but each is also a heavy weight in their respective industries. Merchants and consumers both choose to use Visa cards because their products are trusted and the network of cards are honored in the vast majority of areas. Both companies were also able to automate many of their processes, reducing concerns about labor rate increases. Furthermore, many would consider Coca-Cola's drinks an affordable luxury and spend the few dollars available to purchase a drink.

An auto manufacturer like Ford however, would need to navigate the maze of increased input costs. As mentioned above, both material and labor input costs could pose a problem. Additionally, another problem is that those higher input costs would need to be passed on to consumers...if the company is to maintain profitability. Wages tend to go up during inflationary periods, but the costs consumers incur in their daily lives do as well. Those costs (like healthcare, food, housing, transportation, etc.) tend to constrain consumer spending, at least in the near term, making it difficult for companies to raise prices. This dynamic leaves managers at companies like Ford with two choices. Either they can pass through the cost increases they are incurring (which will likely result in fewer shares and lost marketshare), or they can hold prices steady and try to improve sales volume (but accept that profit margins will decline and profitability will be adversely affected.)

In a commodity business, where there is little differentiation between the offerings of several different companies, it can be remarkably tough to pass increased costs on to customers. We can argue able whether or not a company like Ford would be able to pass those costs on, but I would expect most investors to be in agreement about the ability of Coca-Cola or Visa to raise prices. These types of businesses make more attractive investments, in my way of thinking. Click the following links if you would like to read my company specific thoughts about outlook for Coca-Cola and Visa, respectively.

Disclosure: Long KO and V. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional.

Disclosure: I am/we are long KO, V.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.