Hedge Inflation With Pricing Power

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Editor's Note: The initial article referenced Philip Morris owning food brands. This is no longer correct. This version has been corrected and Motley Fool apologizes for the error.

With interest rates at historic lows and a federal government that cannot afford to have its interest payments rise, the Federal Reserve's unprecedented Quantitative Easing program has no end in sight. Cheap money inevitably leads to inflation. So, whether it is apparent in current economic statistics or not, above-average rates of inflation are undoubtedly in our future.

Inflation has a disproportionate impact on the poor and elderly. The poor spend most of their income on essentials like food and gasoline, which are extremely sensitive to inflation. Meanwhile, the elderly usually own bonds and other "safe" assets that destroy purchasing power during periods of high inflation.

But the poor and the elderly are not the only ones in trouble when high inflation creeps its way into the economy. For many companies, an increase in the price of raw materials and other inputs will crush margins and lower profits. So even people with a high allocation to equities will feel the pain of high inflation.

That is, except for investors who own businesses that have pricing power. Pricing power is the key to outrunning inflation. Companies with pricing power can pass on higher input costs to their customers that keeps profits growing at least as fast as inflation. These are the stocks you want to own in all economic environments -- but especially during periods of high inflation.

A Few Companies with Pricing Power

Philip Morris International (NYSE: PM) is an example of a company with pricing power. Philip Morris has nearly a 1/3 share of the markets in which it competes most heavily. This is due to the company's strong tobacco brands, the most famous of which is Marlboro. The addictiveness of its tobacco products lends itself to customer stickiness, but the excise taxes placed on sales of cigarettes also benefits the company. The price of all cigarette brands are already high because of the taxes, and customers have shown that they are willing to pay a few bucks more for their favorite brand.

Walt Disney (NYSE: DIS) is another company that can keep margins up amid high inflation. The company owns valuable TV networks, like ESPN, that dominate their segments. Disney also owns theme parks, countless hit movie franchises (and associated merchandise), and a strong brand name that makes nearly everything it touches golden. A one-of-a-kind business like Disney can maintain margins by raising advertising rates (for its TV networks) and raising prices of valuable merchandise.

Finally, PepsiCo (NYSE: PEP) is a company whose pricing power is overshadowed by its biggest competitor -- Coca-Cola. Coca-Cola may get all of the credit for having a loyal customer base, but Pepsi drinkers are just as loyal to Pepsi as Coke drinkers are to Coke. PepsiCo has similar economics to Coca-Cola, except Coca-Cola does not have a dominant snack food business. Frito-Lay (owned by PepsiCo) is the world's largest snack food company. Frito-Lay benefits from the same brand loyalty that benefits Philip Morris's products, which gives it a high degree of pricing power.

Bottom Line

Inflation or no inflation, it's hard to understand why people insist on owning companies that do not have pricing power. These companies are special -- they can raise prices without losing customers. That's like being able to walk into your boss's office and get a salary raise at will.

These are great businesses that will thrive in all environments, but they are about the only companies that will do well in an environment of high inflation.

Warren Buffett invests in companies that have pricing power. Shouldn't you?

titans8904 has no position in any stocks mentioned. The Motley Fool recommends PepsiCo and Walt Disney. The Motley Fool owns shares of PepsiCo, Philip Morris International, and Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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