The S&P 500’s overall profit margin hit a record in 2021. But that’s old news, and the current environment is much more challenging. A point of differentiation for companies in 2022 will be the ability to keep profit margins intact or growing despite elevated inflation and slowing economic growth. Their stocks should outperform.
Companies can achieve pricing power in several different ways. A business can sell a good or service that’s vital to customers or limited in supply, giving them no option but to pay up—the product has low price elasticity, to put it in economic terms. That could be gasoline at the only station for miles, toilet paper at the grocery store, or accounting services during tax season.
The fewer direct competitors has a company has, the greater its ability to set prices. A strong brand that has particular affinity or loyalty from customers can also lead to greater pricing power. Think of the typically higher price per unit for
Procter & Gamble’s (ticker: PG) Tide laundry detergent versus the equivalent store brand.
A company can also innovate and improve its offerings, increasing prices as it rolls out the upgraded offerings. If the price hikes exceed the cost of the improvements, that’s pricing power. It’s common in new versions of software, pharmaceuticals and medical devices, semiconductors, and other high tech goods and services.
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Finally, companies can expand their profit margins by becoming more efficient and productive, or by leveraging economies of scale. That brings down the cost of goods sold per unit produced, and increases profits without raising prices.
Companies with pricing power are particularly attractive for the current environment, says Eric Schoenstein, chief investment officer of Jensen Investment Management.
Inflation is running at four-decade highs, affecting businesses’ input costs—investors will want to own those companies that can pass along that inflation. The new inflation dynamic comes just as economic expansion is waning, suggesting slower GDP growth ahead. Stocks of companies that can maintain and increase their profit margins in 2022 should be in demand.
“There are so many cost pressures out there these days,” says Schoenstein, whose Oregon-based firm manages about $14.5 billion. “We’re trying to find businesses that have resilience through those difficult circumstances. The ones that have already been tested and come out the other side should have the ability to do it again.”
Barron’s screened for
companies that grew their gross margin (revenue minus the cost of goods sold, divided by revenue) from 2020 to 2021 as the economy rebounded, but also had rising, positive gross margins in at least the three years before the Covid-19 pandemic. Those that were best able to demonstrate pricing power in a 2% annual inflation environment should be better set up to do it when inflation is running above 7% too. The companies must also have been free cash flow positive in 2020 and 2021, demonstrating their businesses’ resilience through an economic downturn.
The screen yielded 27 names. As with any screen, it’s a blunt instrument that serves as a starting point for further analysis. Here is the list:
|Company / Ticker||Recent Price||Market Cap (bil)||Sector||2021 Gross Margin|
|Hilton Worldwide Holdings / HLT||$150.75||$42.1||Consumer Discretionary||88.3%|
|PTC / PTC||$107.40||$12.6||Technology||79.5%|
|Yum! Brands / YUM||$118.43||$34.2||Consumer Discretionary||73.8%|
|Merck / MRK||$84.87||$214.5||Healthcare||72.0%|
|Zoetis / ZTS||$189.82||$89.4||Healthcare||70.4%|
|Gartner / IT||$297.66||$24.5||Technology||69.5%|
|Microsoft / MSFT||$312.15||$2,341.2||Technology||68.9%|
|Roper Technologies / ROP||$482.51||$51.0||Industrials||67.8%|
|Cooper Cos / COO||$421.38||$20.8||Industrials||66.9%|
|Altria Group / MO||$53.13||$96.5||Consumer Staples||66.3%|
|McDonald’s / MCD||$248.45||$184.8||Consumer Discretionary||65.4%|
|Nvidia / NVDA||$263.50||$656.9||Technology||62.3%|
|Broadcom / AVGO||$615.68||$251.4||Technology||61.4%|
|Mettler-Toledo International / MTD||$1,357.32||$30.9||Healthcare||58.4%|
|PerkinElmer / PKI||$167.88||$21.2||Healthcare||55.8%|
|O’Reilly Automotive / ORLY||$693.92||$46.0||Consumer Discretionary||52.7%|
|Fiserv / FISV||$103.83||$67.7||Technology||49.9%|
|Cintas / CTAS||$433.06||$44.4||Industrials||46.6%|
|Rockwell Automation / ROK||$280.94||$32.6||Industrials||41.4%|
|Xylem / XYL||$87.48||$15.8||Industrials||38.0%|
|Genuine Parts / GPC||$127.78||$18.1||Consumer Discretionary||35.2%|
|Accenture / ACN||$343.82||$217.9||Technology||32.4%|
|Eaton / ETN||$148.65||$59.4||Industrials||32.3%|
|Parker Hannafin / PH||$278.47||$35.8||Industrials||27.2%|
|General Electric / GE||$90.62||$99.9||Industrials||24.3%|
|Packaging Corp of America / PKG||$155.07||$14.5||Consumer Discretionary||24.2%|
|Lockheed Martin / LMT||$451.95||$122.9||Industrials||13.5%|
Several major tech firms make the screen, including
Nvidia (NVDA), and
Broadcom (AVGO). So do healthcare firms like Merck (MRK),
Zoetis (ZTS), and
Mettler-Toledo International (MTD). Their products and services tend to be differentiated from the competition, and rely on constant innovation and updates. Customers’ need or desire to have the latest software, semiconductors, treatments, or medical devices gives the companies pricing power and the ability to maintain profit margins even in an inflationary or decelerating-growth environment.
McDonald’s (MCD) and Yum! Brands (YUM)—which owns KFC and Taco Bell—inflation is showing up in costs of labor, packaging, beef, and other inputs. The fast-food chains are raising prices to offset that on a market by market basis. McDonald’s overall prices rose by about 6% in the U.S. in 2021.
“We are seeing both labor and commodity inflation,” said McDonald’s CFO Kevin Ozan at a conference in March. “Our prices are set by our franchisees …We generally will take smaller, more frequent increases than less frequent large increases. And we do try to tailor all of those increases to the local market.”
Several S&P 500 industrials have been able to consistently increase their gross margins, including
Rockwell Automation (ROK), General Electric (GE), and
Lockheed Martin (LMT). They’re seeing higher expenses for transportation, labor, energy, semiconductors, and many raw materials like metals, resins, and industrial gases.
The companies that pass the screen are employing a variety of strategies to keep their profit margins intact.
Rockwell, which makes factory equipment, is increasing prices alongside its input costs. “We will introduce price increases with a strategy of offsetting what we see for cost increases,” said Nick Gangestad at a conference in March. “In the last six months, we’ve had several announced price increases.”
Cintas, which provides uniform rentals, cleaning, and other office and facility services to businesses, says it is working to bring costs down via automation.
“Pricing is a component of our strategy, but it is by no means the only strategy to combat inflation,” Cintas CEO Todd Schneider said on the company’s earnings call last month. “We’re taking other steps, and they almost all involve technology.”
Some companies are raising prices to offset some of their higher costs, while pulling on other levers to maintain or grow profit margins. “One of the best ways to grow is, of course, innovation,” said GE CFO Carolina Dybeck Happe at the company’s March investor day. “Altogether, the work we’re doing across the company to improve volume and productivity more than offset the headwinds that you see from mix, from inflation, and that investment in growth.”
Write to Nicholas Jasinski at [email protected]