The Best Inflation Hedges Grow in Moats

The U.S. Federal Reserve (“The Fed”) and the Bank of Canada have both recently announced their intention to wind down quantitative easing, tapering the emergency monetary stimulus brought in since the onset of the COVID-19 pandemic. This comes as a surprisingly hot U.S. consumer price index (CPI) reading for October has stoked inflation fears.

Last summer, the Fed changed the wording in its inflation target to “achieve inflation that averages 2% over time”. The Bank of Canada has been consistent in keeping its inflation target at the midpoint between 1% and 3%, but its recent announcement to end quantitative easing could indicate a reversal from the “lower for longer” rate policies taken by many global central banks.

As prior fiscal and monetary stimulus has allowed for superabundant liquidity, inflationary pressures have been magnified by several other factors. Pent-up consumer demand for goods, and the rapid development and distribution of COVID-19 vaccines has granted economies a path to a robust reopening. In addition, labour shortages, higher wage demands, energy prices, and international supply chain constraints have pushed prices higher, complicating and threatening the global economic recovery. There has been less serious debate about the dangers of inflation over the last decade, so its reappearance is cause for concern for many investors. Inflation is necessary for the health and continuity of the business cycle. But excessive levels can have devastating compounding effects, acting as a “silent-tax” on real rates of return.

Natural resource-rich Canada has long been known as a safe-haven of sorts for investors during inflationary periods, as they can seek protection through a diverse range of commodity-based businesses. Inherent to resource production is a direct link to the underlying commodity price, allowing investors opportunities to take advantage of other businesses’ rising input costs. Conversely, the disadvantage of producing commodities is the price-taking nature of the business and high competition, restricting pricing power. While revenues may be linked to inflation, often operating costs and capital expenditures are as well, limiting long-term returns on capital. Within the sector, we believe certain companies will have greater or lesser potential for windfalls. For example, companies that own overriding royalties on production have no direct exposure to operating costs or development capital expenditures; in this case, inflation supporting higher commodity prices is a clear win. There will obviously be varying degrees of business model durability and structural competitive advantages (i.e., “moats”) amongst Energy and Materials companies, but many may find their profitability ultimately at the mercy of the commodity price bullwhip.

While offering less of a direct link to inflation, the two major Canadian railroads are an example of businesses that possess the ability to “pass-through” inflation, which can be attributed to the critical role they play in North American supply chains. As opposed to the pre-1980s regulated environment that capped profits and choked off industry investment in North America, modern railroads operate within a much more constructive environment. Rail freight rates today remain lower than 40+ years ago given the benefits of deregulation, but they have been steadily climbing for the past 20 years as the businesses have grown and significantly improved service levels (Figure 1).

Despite industry-wide protections against competitive abuses, the oligopolistic nature of the railroads and customer dynamics are conducive to earning a compelling rate of return on investments in infrastructure. Both Canadian National Railway (CNR) and Canadian Pacific Railway (CP) boast productive and irreplaceable asset bases and have become significantly more efficient operators in recent decades. They have also subsequently been able to impose fuel surcharges on customers and deliver pricing above rail inflation over time. In the case of CNR, over the past five years corporate same-store pricing has been on average 2% higher than rail cost inflation. And this remains a critical area of focus for the railroads, who have been shortening the duration of typical contracts in anticipation of the more uncertain inflationary environment that we all face today.

Another example of a company that we believe can maintain its pricing power is Waste Connections (WCN). The third largest solid waste company in North America, WCN has a formidable “moat” stemming from its differentiated strategy at scale. Although customers are willing to pay more for reliable disposal of waste, solid waste disposal is generally a “lowest cost provider wins” type of business when the customer has multiple options to pick from. However, WCN’s differentiated market selection avoids ultra-competitive urban markets and focuses on exclusive or less competitive secondary markets that allows for pricing to be determined by the service provider. Not only is their ability to isolate and control pricing attractive, but much of it is also predictable. WCN commonly ties multi-year contract pricing to CPI, with approximately 40% of its business tied to CPI plus an additional cushion of pricing. However, WCN and its competitors fall prey to inflating input costs as well, with recent rises in labour costs and fuel prices. Although scale can help lessen the impact of rising costs, sustainable competitive advantage in the form of pricing power helps to mitigate its effects. WCN further insulates itself by owning local landfills in more competitive markets. This integration allows for more efficient operations, but given the difficulty in obtaining approvals for new landfill construction in local markets, it becomes another avenue for potential pricing power relative to local competitors.

At Franklin Bissett our bottom-up investment approach does not depend on the prediction of short-term macroeconomic trends, but rather our proven skill in identifying businesses that possess some form of durable competitive advantage driving growth in intrinsic values. Although protecting an investment portfolio from inflation may take shape in many forms, a diversified portfolio of high-quality commodity-related businesses complemented by a range of companies with strong pricing power across sectors offers resilience and even potential incremental benefits for those with the ideal “moats”.