Cost deflation and profitability

In a world where commodity prices are under pressure companies with imported raw materials see interesting benefits. Consumer good companies which need flour, sugar, soyabean oil etc are one such example. Other examples are companies which use some sort of oil derivative that includes paints, lubricants etc. The decline in cost in the short term usually leads to margin expansion and higher profitability.

This is where we need to be a bit careful. The short term increase in margins may or may not sustain depending on competitive situation. In a highly competitive sector like cement (particularly when there is overcapacity in the sector), benefits of declining raw material prices can vanish quite rapidly as companies are forced to pass on the benefits to the customers. On the other hand, in a sector with concentrated large companies with strong brand value, companies can delay price cuts for a long time.

If we look at the reverse situation where raw material prices are going up rapidly, companies with unique competitive advantages win. They are able to pass on increased costs to the end customers even though there is a limit to such price hikes (without adversely impacting volumes). However, think of a commoditized sector like fertilizer or cement where there is no clear distinguishing factor between companies. For these sectors, it is often very difficult to pass through increased costs to end customers.

The bottom line is that, in both cost inflation and cost deflation situations companies with strong ‘moats’ are the clear winners. However, it isn’t as simple as identifying these strong companies. The trick for the investor however is to ensure that we don’t overpay for such companies. At the same time, I am not of the opinion that we should only invest in the companies with wide economic moats and avoid the commoditized businesses. At the right price and time, fertilizer or cement companies can also be great investments.

 

Asif Khan, CFA

Asif Khan is presently a Research Analyst (Financial Sector) for Exotix which is a frontier market focused investment bank. He has more than 6 years of work experience as equity analyst in both buy and sell side roles across Asian frontier markets. Asif is a CFA Charterholder and has a dual major in Finance & Economics from North South University.

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