dear investors
Inflation has returned to the agenda of economic concerns both in Brazil and abroad. Despite being a subject with which Brazilians are familiar, most people only understand the impact that inflation has on their daily lives: a general increase in prices of consumer items. However, investors must seek a deeper degree of understanding to understand the impact that inflation can have on their investments and design strategies on how to preserve their equity in inflationary environments.
We will dedicate this letter to the theme. We will explain the main concepts related to inflation and discuss our view on how to conduct investments in the current scenario.
The causes of inflation
The primary cause of inflation is the change in the supply and demand relationship linked to a good or service. Prices rise when supply decreases or demand increases. Having this logic as a backdrop, there are three situations that we can interpret as causing inflation.
The first is the expansion of the monetary base, which is the increase in the amount of money in circulation in the real economy. In short, this is when the government decides to print money. This causes inflation because a country's currency represents the goods that exist in its real economy. Thus, if the quantity of money suddenly doubles, while the quantity of goods remains the same, the price of everything should also double.
The second cause is a sudden reduction in the supply of a product due to manufacturing, logistical or other reasons. In this scenario, consumers of that product will compete for the reduced quantity available. Those who have greater financial capacity, or attribute greater value to the product, will accept paying more to guarantee supply, inflating the market price in general.
The third cause is the sudden increase in demand, linked to an event with a large-scale impact (eg: the demand for hand sanitizer at the beginning of the COVID-19 pandemic) or the heating up of the economy, in which several competing businesses aim to grow and compete for the same suppliers.
Once the sources of inflation are understood, the next step is to understand how price inflation spreads throughout the real economy.
How inflation spreads
For convenience, inflation is usually discussed as a single percentage, analogous to the interest rate, but these two variables behave very differently. In the case of interest, the Central Bank announces the base rate it will consider in its own public bond negotiations, and the entire market quickly adjusts around this rate. In the case of inflation, the percentage we have in mind comes from surveys that measure price changes for a basket of products and services. It is a more imprecise measure.
To clarify the reason for the inaccuracy, imagine that this method of measuring inflation is analogous to spreading some thermometers inside a shed and considering that the temperature inside is the average of the measurements of all these thermometers. With nothing out of the ordinary going on in the shed, this is a good measure. Now, imagine that a fire is lit in the center of the site. Until the firewood runs out, thermometers closer to the fire will indicate much higher temperatures than thermometers farther away. It will take some time for the fire to go out, the temperature throughout the house to become homogeneous, and the measurements on the various thermometers will all be close to the new “house temperature”.
From this analogy, it is important to take two concepts: i) inflation does not propagate instantaneously; and ii) it affects different segments of the economy in different ways. Think of the different segments as the different locations within the house. On a cold night, you want to be close to the fire, and you don't care what the average temperature of the place is. While the average may indicate a bearable temperature, there may be people freezing to death in the corners of the shed and others very comfortable by the fire.
Looking at the real world, the war between Russia and Ukraine has suddenly diminished the global supply of oil, as Russia is a major producer and has suffered embargoes from across the West. Thus, oil became more expensive, while its production costs remained the same, increasing the profits of other oil producers, that is, these were the beneficiaries of oil price inflation. Businesses that consume oil on a large scale are in a different position: they may have the power to pass on prices to their own customers, preserving their profitability, or they may be forced to sacrifice profitability to maintain their own demand. However, there is no scenario in which consumers of inflated products benefit.
As a general rule, businesses that manage to increase the price of what they sell before suffering pressure from their suppliers, and seeing their own costs increase, are the ones that benefit from the inflationary environment. The key is having pricing power.
Where does current inflation come from?
Today we are going through an inflationary cycle caused by two major events. The first of these was the pandemic, which had a double effect. At the same time, it disorganized several production chains, reducing the supply of various products and services, and forced governments around the world (including Brazil) to print money to distribute aid to the population weakened by the lockdown. The second was the economic sanctions package that came into effect due to the war between Russia and Ukraine, which restricted the movement of several important commodities, in particular oil.
In this context, inflation is inevitable. The expansion of the monetary base, carried out in relevant volume, is not an easily reversible movement. Sanctions are even reversible from a theoretical point of view, but wars tend to be prolonged and the trauma of countries that depended more on Russia, and suffered from the interruption of trade relations with it, caused a broad movement around the world of “deglobalization”, whose impacts are complex to analyze.
Deglobalization can have inflationary impacts in some parts of the world and deflationary impacts in others. If a country that relies heavily on imports decides to limit the number of suppliers it wants to deal with, its total cost of imports can only rise. Thus, that country must increase inflation in its own economy. On the other hand, countries that depend on exports and can see their old customers moving away, will maintain their productive capacity and will see their demand decrease, so their export products must have their prices reduced.
It is very difficult to analyze in detail how each business will suffer or benefit from inflation over time. It's like there are bonfires popping up and going out randomly in our imaginary shed, and we have to choose the best place to sleep through the cold night. Thus, the best alternative is to focus on the microeconomic analysis of each business and seek to understand which businesses have the power to pass on prices.
The pricing power
In essence, this power depends on how essential the product or service offered is and how irreplaceable it is. For example, the demand for fresh water is completely inelastic. We would all die after a few days without water and the demand for it is cumulative (going without drinking water for a day does not decrease your total demand for the week, as the next day you would need to drink more water than normal to hydrate). Thus, if there is a shortage of potable water in a given location, whoever has water would have almost absolute pricing power (until the government appropriates it in the name of the collective good). There is no way to exactly measure this pricing power, but it is possible to analyze it qualitatively, see the two examples below.
We know that there is no viable substitute for oil, and that many industries are completely dependent on it. In addition, oil stocks are small when compared to the volume recurrently consumed. So, it's difficult to postpone oil consumption much due to the current price. That's why oil producers have strong pricing power.
On the other hand, a manufacturer of designer clothes could easily be replaced by a manufacturer of cheaper brands if their customers have reduced consumption power. This business would be much more fragile in an inflationary environment, and would have to choose between losing volume or reducing prices, sacrificing profitability.
As nothing is that simple in investing, not every business with pricing power will be a good investment. We are paying attention to the point due to the expectation of inflation, but it continues to be just one of several factors that need to be analyzed before any investment.
Evaluated alternatives
By this pricing power criterion, an alternative would be to invest in companies that produce commodities, which would certainly protect us against inflation. However, commodity prices are already quite high and, in many cases, the market already considers these new price levels in the assessment of commodity producing companies. In other words, many of these stocks aren't cheap. We don't like the idea of investing in businesses like this when they are at the peak of their product price cycle, as there is a significant risk that commodity prices will fall in the future and, in this scenario, buying these stocks now could be a bad investment. Thus, the protection against inflation that commodity businesses provide would pay off only in cases where the stock price of these companies is not inflated by optimistic market expectations. We have not eliminated the possibility of investing in this type of business, but the prices of the companies we evaluate, for the time being, are not attractive.
We would also have other means of avoiding the risk of inflation. We could, for example, allocate more capital to fixed income or real estate funds (although Ártica Long Term is an equity fund, we can allocate up to 1/3 of the fund to other asset classes). Thus, our view on these alternatives follows.
Fixed income doesn't seem like a good idea at the moment. In our 2021 annual letter, we talk about interest cycles and stock performance. In short, high interest rates are the best time to buy stocks, not to invest in fixed income, as this is when stock prices are most attractive. Inflation protection is also not as efficient in fixed income, even in post-fixed or hybrid securities (adjusted by the IPCA), as there is a risk of inaccuracy in the official inflation indicator. Some big investors have been saying that “cash is trash”. They refer to the risk of erosion of the real value of money, which we would be exposed to if we left more money in fixed income. That is, the ideal now is to invest in real assets (including stocks).
Real estate funds seem cheap, in relation to historical prices and properties preserve their value in inflationary environments, but these funds were attractive mainly due to the high interest rates, the same reason why shares are also cheap. Comparing the potential return of this alternative with that of the stocks that we have already identified, stocks seem to us to have potential returns much higher than real estate funds, so there would be no advantage in allocating capital to this asset class at this time.
Conclusion
We chose to maintain the strategy of gradually allocating our cash, which today is close to 10% of the fund's equity, in good deals. Pricing power has always been an important criterion for us, as it has a strong correlation with the quality and sustainability of the business. Thus, most of our investees should continue to do well, even under high inflation. Some of them are exposed to a greater risk of losing demand if inflation is very high for a long period, but this risk is largely offset by the fact that we are buying shares in these businesses at very attractive prices, with an unusually high margin of safety.
We remain confident with our theses, and we express this confidence with our own capital. Ártica's partners and professionals from our Asset Management team are among the people who invested the most in Ártica Long Term FIA this year. We intend to continue making new contributions over the next few months, following our traditional strategy of splitting contributions over the period that we believe is a good time to invest.
