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To Pass Through Or Not To Pass Through

CAMS Weekly View from the Corner – Week ending 11/19/21

November 22, 2021

We have sprinkled the “stock’s can act as pass-through vehicles” concept throughout various editions in the fall season.  Reduced to simplicity, an on-going profitable business is continually do this to the degree they can while simultaneously trying to maintain, if not grow, their customer base. This is simply the process of passing through increased costs in the production process and/or retailing of those products to end consumers.  There can be a delicate balance between trying to maintain a company’s profit margins (by passing all price increases through) on one hand while not pushing price sensitive customers away on the other hand. Adding to this is the various industry mixes that come into play.  Some industries are traditionally able to pass through costs easier to consumers because of their necessity to end consumers.  Think furnace repair parts in the dead of winter.  Anyone going to get real price sensitive when the family is cold?  Even in these type of industries their remains a competitive aspect within the industry.  Can you really afford to raise all your prices to the degree you are incurring cost increases in your production lines if your competition is not?  (Yet again, as an aside, the positive of competition in the market place for end consumers.  Competition increases quality, selection and pricing of goods and services.)    Inflationary Times When inflationary periods take hold society begins to reconfigure itself as the inflationary experience unfolds.  Relative to providers of goods and services this pass-through process becomes notable. Market participants have taken note as 2021 has unfolded in that they have been rewarding those who have or can pass-through more than others.  In fact, whole industries have been getting bids because of the nature of their ability to pass through large cost increases to end consumers.  Auto parts and retailers of those come to mind.     For our part we have had many internal discussions and breakdowns in 2021 on this in the process of selecting investment candidates.  Simply put, where does “x” company or industry come down on the pass-through view?  This has been a continual question on the analytics table in light of our disbelief of transitory inflation beginning back in the early spring season. Making It Up On Volume This past week we welcomed mainstream media to the pass-through topic when we seen a headline offering that investors are rewarding those (in this case broad big box retailers) companies who are willing to increase prices to consumers.  (Hiking prices or passing-through – different descriptive language but same end story.) For their part they focused on retailers differing approaches toward this topic in that some are choosing not to raise prices as much as they are incurring cost increases.  Now we are beginning to see some are openly stating they are doing everything they can not to raise prices in order to serve their customers.  Here they are saying what we offered earlier; they are choosing not to push price sensitive customers away while realizing their profit margins will go lower while doing so.  Lower profit margins are something collective stock market participants do not get excited about unless they can make it up on volume.  Said differently, lowering profit margins by not raising prices as much as necessary while simultaneously increasing customers equals the making it up on volume approach. That is, make less profit per transaction but sell a lot more product whereby the business is less profitable but grows in light of the notably increased volume of sales. This is in theory but theory often doesn’t translate to reality. Producer Price Inflation To pass through or not to pass through cost increases by businesses is becoming a notable topic that is apt to continue on longer than most appreciate. As consumers we know our price inflation is at multi-decade highs with the most recent CPI registering 6.2%.  Producers too have their own price index known as the Producer Price Index and it too is coming in red hot.  The most recent reading for this measure was 8.6% for the second consecutive month. Below we share a ten year visual of the Producer Price Index to get perspective of the price challenges in the producer pipeline.

Worse, deeper in the production pricing pipeline where there are producer pricing measures for various stages of production the price inflation data are registering double digits.  The significance is producers and retailers will be contending with this question of whether to pass these costs through to consumers for the foreseeable future as the pipeline that serves them is filled with price inflation.  This will impact the consumer hat we all wear for obvious reasons.  This will also play a role for the investor hat we may all wear in that challenging profit margins and off-the-chart stock price valuation levels historically do not get along well.  Collective market participants will continue to view those companies favorably who can maintain their profit margins while simultaneously not losing much of their customer base. Over time, during inflationary episodes that achievement becomes more and more difficult and with this pricing of stocks becomes more volatile with the uncertainty that price inflation causes.  I wish you well…

Ken Reinhart

Director, Market Research & Portfolio Analysis

Footnote:

H&UP’s is a quick summation of a rating system for SPX9 (abbreviation encompassing 9 Sectors of the S&P 500 with 107 sub-groups within those 9 sectors) that quickly references the percentage that is deemed healthy and higher (H&UP). This comes from the proprietary “V-NN” ranking system that is composed of 4 ratings which are “V-H-N-or NN”. A “V” or an “H” is a positive or constructive rank for said sector or sub-group within the sectors.

This commentary is presented only to provide perspectives on investment strategies and opportunities. The material contains opinions of the author, which are subject to markets change without notice. Statements concerning financial market trends are based on current market conditions which fluctuate. References to specific securities and issuers are for descriptive purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. There is no guarantee that any investment strategy will work under all market conditions. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. PERFORMANCE IS NOT GUARANTEED AND LOSSES CAN OCCUR WITH ANY INVESTMENT STRATEGY.

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