Leaders, however, are the disruptors who have executed successfully over the long term and now represent the best in their field. They are highly profitable so they can pay a dividend. Moreover, their rare ability to continue to innovate and sustain their leadership position means that they will also protect that dividend and grow it.
Think of Estee Lauder, which needs little introduction as a long-standing global leader in cosmetics, with many of the best brands in the industry and the number one global market share in prestige cosmetics. Over the past decade or so it has embraced online and digital distribution strategies to keep its brands relevant to a new generation of consumers with very different shopping habits to previous generations. It has delivered 14 per cent average annual dividend growth and 275 per cent share price growth over the past 5 years.
How might Estee Lauder navigate stagflation? Well, through its reputation for the highest quality products and the building out of its own digital distribution it retains much stronger pricing power and control than if it had to rely on Amazon and other e-commerce platforms. So, it is a well-positioned income stock for stagflation.
Another example is United Health, the largest manager of healthcare benefits in the US, covering 50m members. One thing one can say about stagflation is that it is already here in the US healthcare system. US health care spending represents around 18 per cent of GDP. This is twice the OECD average and it has not bought the US better quality outcomes.
United Health is innovating to fight this stagflation using data to make the system more efficient and responsive to evidence on outcomes. It has delivered 20 per cent average annual dividend growth and 225 per cent share price growth over the past 5 years.
We believe that such companies are the best income stocks in the market in today’s economy and will navigate stagflation the best. We see many of the classic types of income stocks today as structurally vulnerable to disruption through innovation and unable to adapt. They may pay enticing high yields, but those yields are high for good reasons. In many cases, stagflation would likely be the final straw for them.
Stagflation and interest rates
A consideration for our thesis that innovators are the best stocks for stagflation is that innovators are growth stocks and growth stocks would not like the rising interest rates that would likely feature in a stagflationary world. We think the lasting impact of stagflationary rising rates on innovative companies would likely be a lot less than is sometimes argued.
If bond yields rise simply as compensation for higher inflation, then all that really matters is a company’s pricing power, so that its cash flows rise as the stock market’s discount rate rises. And we would rather have an innovator’s pricing power (like Estee Lauder), or alternatively its ability to substitute new cheaper inputs (like Costco), every single time.
