Supply Matters - Majedie

Supply Matters

Mark Wharrier believes companies with pricing power and cost advantages have competitive strengths now and should shine when demand returns.

Reading time: 5 minutes.

Pick businesses where there is more demand than supply and you won’t go too far wrong. A simple philosophy perhaps, but one with inescapable logic – the positive gap between the two usually leads to superior returns, cash flows and enriched long-term shareholders. The key is how the strategy and capital allocation of the company can sustain the gap.

While much of the intellectual processing power of stock market participants is devoted to analysing demand (sales) – there is less focus on the other side of the equation, supply. Perhaps it is because measuring sales is relatively straightforward; analysing supply is more complex, particularly as capital expenditure and physical presence become less constraining factors on output. The quality of the franchise, the investment in intangibles such as people, digital capability, new products and functionality, and the resonance with customers are increasingly the factory capacity or retail square footage of old.

However, control of supply whether it be physical or intangible is a quality we are devoting a fair amount of our intellectual processing power towards at present. Clearly the near-term environment is one of deflation given the sudden shortfall in demand as a result of Covid-19, but the medium-term environment is less clear. The combination of prodigious central bank money creation, eye-watering levels of prospective government debt and an electorate who (outside Germany it seems) have little appetite for further government spending restraint all point to a less deflationary environment over the medium term. We should expect further policies of financial repression over the medium term, namely suppressed interest rates which are likely to be negative in real terms for some time.

Is this an environment where value shares will finally blossom like a plant which has failed to flower for so many seasons? To be sure, some lowly valued shares will undoubtedly perform and valuation will be an important contributor to future investment returns, but ‘cheap’ companies which are capital intensive, carrying too much debt and with structural problems, and consequently have little pricing power, will not.

Pricing power backed by cost advantages: a profitable mix 
Free cash flow generation and healthy returns will be the key drivers of equity returns (they always are) but companies which have latent pricing power are particularly attractive given this new environment, and appear in a wide variety of sectors. Many sectors that have traditionally had pricing power are likely to be less potent going forward; regulated (and over-levered) businesses such as utilities and telecoms are likely to suffer ongoing political interference to keep consumer bills low; banks which do not have competitive advantages are unlikely to be able to price products for real risks given forbearance pressures and businesses which have relied on real estate as a distribution channel are unlikely to benefit given digital alternatives.

In our view, the cost curve position of a company is critically important when identifying pricing power, particularly for those companies that are in a position to grow market shares through investment in technology and people rather than those large operators with an ‘incumbency’ mentality. This cost advantage may arise from market share and scale advantages (e.g. Direct Line Insurance, Sampo, Electrocomponents, Domino’s Pizza, Hays) or through ownership of advantaged assets such as Mondi operating in structurally low-cost geographies.

On this basis we started a new position in Rio Tinto during the month. While the demand outlook is clearly uncertain, sector balance sheets are in a much stronger position following the high indebtedness during the 2016 downturn and the period of subdued capital expenditure which followed. Most importantly the company owns some of the lowest cost and longest life assets in the industry. For example, in its core area of iron ore, along with BHP, Rio Tinto is a key operator at Pilbara in Western Australia where unit costs are approximately $14 per ton of iron ore. The chart below from Bernstein was highlighted to me by a colleague and shows industry returns over the past 35 years by cost curve quartile – unsurprisingly those resource owners with costs in the first quartile generate far superior long-term returns. This is a robust supply curve which will still demonstrate cyclicality but has the ability to generate healthy long-term returns for Rio Tinto. Importantly, Pilbara is a crucial part of the Western Australian economy and there is a symbiotic relationship between the success of the asset and local tax revenue. In an environment where we expect much more government interference, this supply discipline and de facto tax collector role are likely to be important investment characteristics and we are seeking to identify them in other companies across the wider market.

Figure 1: Average ROCE by commodity and cost position 

Source: Bernstein analysis

The philosophy of a company is also important – companies that focus on delivering good value to their customers rather than price gouging them during the good times are likely to have more latent pricing power in the future. RELX, for example, which has migrated its databases and services online over the past two decades, has always ensured pricing lags usage, which demonstrates greater value for money for the customer and helps secure longer-term revenue visibility. Roche has recently launched a COVID-19 antibody test which it will sell in the tens of millions, but which will be priced at a normal margin in order to promote long-term diagnostics take up and prompt a more balanced discussion with customers on pricing in its wider drug portfolio. Tesco, under David Lewis, has moved price points to highly competitive levels, in many cases head to head with the German discounters to justify customer loyalty and sustain a high market share. A similar thinking drives AB Foods’ Primark and 3i’s Action businesses.

These examples may seem intangible and removed from the current economic drama, but they are important indicators of latent pricing power, which have the potential to drive returns and relative share prices once we emerge from a less deflationary backdrop. We expect there will be greater polarization between companies’ performance in this more hostile economic environment and we will continue to focus the portfolio towards those businesses which have the return, free cash flow and industry structure qualities that have the ability to generate both strong total return and income over the medium term.