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Companies with extraordinary pricing power are the backbone of healthy portfolios in inflationary times, says Kathrin Forrest, an equity investment specialist with Capital Group Canada.

Given May’s posted inflation rate of 7.7% in Canada and 8.6% in the U.S., she said it’s time for equities investors to be more selective.

“Some companies are much better positioned to navigate higher inflation,” Forrest said. “An active portfolio of select companies with strong pricing power can help investors thrive in the years ahead.”

Speaking on the Soundbites podcast, she said wages and raw materials prices have skyrocketed, with the latter rising by 38.4% for manufacturers operating in Canada in May.

“As companies face higher costs, their profit margins, earnings and ultimately returns for investors are put under pressure unless they can raise prices without meaningfully impacting demand for their products. And that is what pricing power refers to.”

Forrest said certain industries and companies have more flexibility to adjust prices. In the pharmaceutical industry, for example, supply is generally protected by patents. In the case of luxury goods, brand recognition and exclusivity limit price sensitivity. And in the tech space, highly specialized companies like computer chip manufacturers enjoy greater pricing latitude because of the uniqueness of their products.

Among such companies, she said, even greater advantage is conferred on those with high and stable margins, as well as those at low risk of facing disruption or new competitors.

“A really good example of a company with strong pricing policy is the Dutch chip component manufacturer ASML [Holding NV],” she said. Within an industry marked by roaring demand and consolidating supply, she said ASML is well-placed to thrive.

“Then, in a very different industry, we could take a look at [Minn.-based] UnitedHealth Group,” she said. “Managed care companies like UnitedHealth Group are focused on reducing inefficiencies in the U.S. health care system. By delivering more value, UnitedHealth can maintain its pricing power while it also helps tackle a long-term problem in the U.S. health care system.”

But there are limits to pricing power, she said, as streaming service Netflix Inc. learned recently.

“It goes back to sustainability, how resilient demand is, and how much risk of disruption we see,” she said. “Netflix has increased subscription rates in the U.S. four times since 2014. And that was in an environment where they saw robust subscription growth globally. They’ve seen more limitations to that subscription growth more recently.”

Forrest said the fickle side of pricing power can be seen in the soft drink industry, where consumers might pay more for their favourite brands. But if the premium is too high, loyalty goes out the window.

“Soft drinks might have brand recognition and pricing power to a degree, but ultimately there is an ability for customers to switch to other products if they feel they’re not getting value for their money,” she said.

Her considerations about pricing power have led her to look for deeper structural qualities that will help companies offset the pressures of inflation.

“While we continue to look at pricing power, broader considerations around resilience have moved into the spotlight as well. They include strong cash flow generation ability, solid balance sheets, good capital allocation, and experienced management,” she said.
This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.

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