At this point, there's one thing we can probably all agree on when it comes to inflation: it's not transitory.
So then the question is, can long-term investors protect their portfolios against inflation?
Absolutely. History shows us that the average annual inflation rate of 3% is greatly outpaced by the 10% average annual return of the S&P 500 over the same period. When picking individual stocks, quality is the best defense to continue outpacing inflation, even as its rises above the average.
Here are four indicators of high-quality businesses that are likely to outperform the market during extended periods of rising prices:
1. Pricing power
One of the best defenses a company has against inflation is pricing power. This is the ability to pass higher cost of goods or services on to the customer.
Costco (NASDAQ:COST) is a perfect example of a company with strong pricing power. It has an extremely loyal customer base as is demonstrated in its 92% membership renewal rate, and it sells products everyone needs.
If you combine this with its growing e-commerce business (which posted 14% revenue growth last quarter), you have a high-quality company that is not only poised to weather the inflation storm, but also achieve new heights.
2. Network effects
Network effects are one of the most powerful economic moats. This is a phenomenon where the value of a service or product improves as more participants join.
The most obvious example of a network effect is the telephone. There was very little value when Alexander Graham Bell invented the first telephone because no one else in the world had one. But as more and more people started using telephones, the value of the network increased exponentially.
One of the most powerful network effects in the world today can be seen in payment processing companies like Visa (NYSE:V). The more merchants that accept Visa cards, the more account holders are likely to use the cards and vice versa. The convenience, security, and rewards programs enjoyed by cardholders make it very unlikely that inflation will have a substantial impact on this business, as can be seen in the 16% increase in Visa payments volume in 2021.
3. Switching costs
Another way companies protect themselves from inflation are switching costs. Switching costs refer to the price a consumer has to pay in order to switch brands or products.
Consider Adobe (NASDAQ:ADBE). While there are certainly cheaper alternatives to its suite of design software products, there are tremendous costs associated for businesses to switch to those competitors. The business needs to research the best alternative, leverage its IT department to make the change, and then retrain its employees on the new software.
Most companies are willing to pay a higher monthly subscription to avoid the cost and headache of switching, which is likely in part why Adobe was able to post record revenue of $4.11 billion in the most recent quarter.
One of the leading indicators of a quality business is net profitability. A company is profitable when it has income leftover after accounting for all expenses. This is also known as earnings or net income.
If you're anything like me, your portfolio probably includes a few high-growth technology companies. These stocks tend to experience higher volatility during periods of inflation and higher interest rates as the market looks for current earnings instead of future earnings. But not all growth stocks are made equal.
A company like The Trade Desk (NASDAQ:TTD) which is in the middle of it's hyper growth stage but also solidly profitable looks much more attractive during an inflationary trend than a company like EV maker, Rivian (NASDAQ:RIVN), which is not only pre-earnings but pre-revenue.
By now, you're probably catching onto the theme: business quality is more important now than ever.
The bottom line
The great luxury of being a long-term investor is getting to largely ignore macro-economic worries.
Legendary investor and chairman of Berkshire Hathaway (NYSE:BRK.A), Charlie Munger said it best at the company's 1994 annual meeting: "If you're agnostic about those macro factors and therefore devote all your time to thinking about the individual businesses... it's a way more efficient way to behave."
Inflation may be here for years, or it may be here for months, no one really knows. This uncertainty can be really unnerving, but I take comfort in knowing great businesses are not dependent on strong macroeconomic conditions. They continue to succeed over the long term -- growing patient investor's portfolios right along with them.