Inflation expectations are on the rise as the economy strengthens from the pandemic-induced recession. Locating companies that have significant pricing power and profitability going forward could be a key to finding the best stocks.
Market-implied inflation expectations hit a yearly high of 1.9% Wednesday evening. That’s up from a low of 0.8% in March.
This trend favors economically sensitive sectors like consumer discretionary and manufacturing, which see an outsize uptick in demand going into a new economic expansion, over more-defensive sectors like consumer staples and utilities.
Consumer-brand companies can enjoy pricing power as well, and identifying those companies can add another additional layer of security in picking names that can drastically expand profits.
The key to identifying these names is that their pricing power is a meaningful contributor to the expansion of profit margins, which enables companies to grow earnings aggressively. The average operating margin of the S&P 500, after dipping in 2020, is expected to expand to 15.8% in 2021 and to 16.6% in 2022, according to FactSet. That would help power earnings-per-share growth to 23% and 17% for 2021 and 2022, respectively.
But some companies are expected to see above-average sales growth and margin expansion. Margins for manufacturers get a double tailwind, as many of those producers have a high portion of their costs as fixed costs. These costs don’t very much, so when sales expand, margins expand aggressively.
Wages and salaries—which rose 2% year over year in October—are back to pre-pandemic levels, according to research from RBC Capital Markets economists, acting as a drag on profit margins. Higher wages usually lead to inflation, as companies pass the cost onto consumers. “Hence, the notion of pricing power becomes crucial to maintain or grow profitability,” wrote Tobias Levkovich, chief U.S. equity strategist at Citigroup, in a Wednesday note.
Citi offers a list of companies with strong pricing power.
John Deere (ticker: DE) is high on that list. Deere is benefiting from an upturn in the agriculture cycle. Pricing power “is a tailwind for margins for Deere,” Matt Arnold, industrials analyst at Edward Jones, told Barron’s. Deere has recently been tracking at roughly 3% pricing growth year over year, and Arnold expects the company to remain at the higher end of this range, which is usually between 2% and 3%.
Deere, Arnold said, has invested heavily in building the right machines for farmers and has beaten the competition. The stock is up 22% since Sept. 23, the start of a fresh rally in stocks, outpacing the S&P 500’s 15% gain. Deere’s EPS is expected to rise almost 80% between 2020 and 2022, nearly doubling the average stock on the S&P 500.
Also on the list is Union Pacific (UNP). “Railroads have been very successful in lifting pricing as well, given limited capacity,” Levkovich noted.
Another name is Westlake Chemicals (WLK), a $10 billion market-cap company selling into industrial and consumer end markets. Its prices for plastic products are particularly cyclical. Levkovich said its pricing power “could be related to the reopening economic rebound.”
FedEx (FDX) is also on the list. The explosion in e-commerce in 2020—a secular trend expected to continue in the future—has driven demand and pricing for FedEx, Arnold said. FedEx and United Parcel Service (UPS) are two of the only delivery companies that can capture the world’s need for e-commerce delivery.
As for the consumer, Nike (NKE) is high on Citi’s list. Nike is known on Wall Street for selling at full price because of its strong product curation, driven by an intimate knowledge of its customer. That knowledge partially stems from the company’s digital sales, which feeds customer data to management.
Joe Feldman, an analyst at Telsey Advisory Group, told Barron’s the pricing helps Nike’s margins, but the company is also benefiting from moving more of its sales to its higher-margin direct-to-consumer business. Nike is expected to grow EPS more than 130% from 2020 through 2022.
Write to Jacob Sonenshine at [email protected]