Sustainability of growth holds the key to beating inflation

Jean-Pierre du Plessis, Director and Portfolio Manager at Stonehage Fleming Global Equity Management

South African inflation is predicted to average around 6% in 2022, potentially peaking at around 7% this year[1]. South Africa is not alone in experiencing inflationary pressures, with elevated inflation levels eating into consumers’ disposable income across many major global economies.

The good news is that historically, equities have proven to be a good hedge against inflation over the long-term. By investing in companies with attractive and more importantly, sustainable growth prospects, investors have a strong chance of beating inflation over the long-term.

Jean-Pierre du Plessis, Director and Portfolio Manager, Stonehage Fleming Global Equity Management (South Africa) says that when investing for sustainable growth, investors should look for the optimal blend of quality, longer-term return upside and appropriate risk in all businesses they invest in.

“Characteristics such as healthy and predictable cash generation, strong pricing power, sustainably high returns on capital, and attractive growth opportunities are all important when identifying best in class businesses,” says du Plessis.

While it is relatively straight forward identifying companies that have delivered attractive growth and high returns on capital in the past, du Plessis argues that is more difficult to recognise the attributes that enable a company to sustain this growth in future and ultimately generate inflation beating returns for investors.

In his view, it is important to consider the company’s growth drivers, cost of this growth, the management team’s circle of competence and lastly the probability of the company achieving these growth ambitions.

Growth Drivers

Company growth drivers can include sustained high levels of revenue growth, expanding gross margins or operating efficiency or an improving cash flow production relative to earnings.

Investors should look ahead at where a business is going in order to gain a better understanding of what to expect in future: will it be more of the same, or will the business need to make significant pivots into new markets, products or geographies in order to survive?

“The JSE is littered with companies that have made investments outside of their competency and have paid the price. Clicks is an example of a business that is still showing attractive growth drivers at both bottom and top lines through continued growth in their core business, expansion in new sectors and continued efficiency gains, ” says du Plessis.

Stable Cost of Growth

While a healthy growth rate is important, it is vital to assess the cost of this growth to the company. Ideal companies are those with stable or rising returns on capital, due to higher returns produced on each incremental rand invested. Investors should look for capital light compounders that are able to grow without heavy investment.

Du Plessis highlights Discovery as a business that has experienced a trend of rising cost of growth in the recent past.

“Discovery has been investing into new initiatives and has thus experienced the associated rising costs of new business. Looking ahead, we predict this cost of growth to reduce as emerging businesses scale up and losses in the bank are forecast to decline.”

Management Circle of Competence

This is the area of business that management knows intimately and has a proven operating track record. Companies where management is looking to achieve future growth within its areas of competence can provide greater predictability of returns on capital.

A good business case is niche operator Transaction Capital, which du Plessis believes has demonstrated a clear competence within the SA Taxi and more recently used car sectors.

“With a number of years of strong growth behind them and an established dominant domestic position, recent offshore expansions could be considered to be outside of management’s circle of competence,” he says. “Considering the different market dynamics, there is still uncertainty surrounding their success in these new geographies, although these investments remain small in their lives.”

Probability of Success

To help investors assess how likely a business is to succeed in its future growth aspirations, it is key to look at management’s track record, the strength of the business, growth prospects, cost of growth and whether growth is expected to occur in an area of management competence. A business with a high probability of success in delivering on their growth prospects is ideal.

“In the case of Richemont, the strong growth experienced across divisions over the past two years provides evidence of the durable value and quality of the group’s brands, after a number of years of more moderate growth. The group’s economics, cash flow, returns and balance sheet have meaningfully improved, in our view enhancing the business’ probability of future success.”