While country risk has manifested itself this year most obviously in the shape of geopolitical risk, arguably the bigger impact from Russia’s invasion of Ukraine on our target geographies will be the commodity price shock. In some cases, the news is positive. Brazil, for example, receives a welcome boost to its public finances from growing exports. The strengthening of its currency may help the country to escape from its monetary tightening cycle ahead of international peers, aided by the fact it kickstarted the process earlier in 2021 given the effects of a local drought on local energy prices (predominantly hydroelectric). Neighbouring Argentina, Chile and Colombia (commodities), as well as Mexico (‘near-shoring’) also appear well-placed for the months and years ahead, having been unfashionable corners of the EM universe in recent times.
Amid a mixed Asian picture, Indonesia stands out as a likely winner. While far from immune to rising import costs, particularly oil, India and China at least display a strong domestic demand profile and economic complexity which should help protect them from the fallout of accelerating de-globalisation and weakening foreign investment flows.
In other locations the news appears more negative. Egypt, for example, is both highly dependent on commodity imports in general, and specifically on wheat from Eastern Europe. Given the importance of wheat as an everyday staple, the social ramifications of higher bread prices are potentially severe. It has been widely remarked that in the middle of the last decade, food inflation was a major catalyst of the Arab Spring, and eventually a sharp (~40%) devaluation in the Egyptian Pound. There are many signs that the government is responding much more proactively to the situation this time round. It has sought early assistance from the IMF and allies in the Gulf, reacted promptly to identify alternative domestic and foreign wheat supplies, and has not repeated the mistake of allowing a tsunami of selling pressure in the Egyptian Pound to build up behind misguided capital controls. But some short-term pain is inevitable.
The other main lens through which to assess inflationary impact on our investments is relative business model vulnerability. Our research team has undertaken a comprehensive appraisal of each of our holdings’ exposure to escalating input costs; their margin buffer; elasticity of demand; and inflation in terms of capex requirements. Taking a simple average approach to all current Arisaig holdings, some of the key conclusions from the study are:
- Less than 15% of our holdings’ total costs are likely to be exposed to significant inflationary pressures;
- Our analysts rate c.80% of our holdings’ products / services to be difficult or very difficult to substitute at a lower cost;
- More than 80% of our holdings stand to benefit from formalisation and / or consolidation of markets they operate in;
- Our holdings in aggregate have a net cash balance sheet with average gross margin of 50% and EBITDA margins of 23% providing sufficient buffer to protect against inflationary pressures.
Generally speaking, our digital names should be quite well set due to their more dematerialised, asset-light business models, and inherently high operating leverage. For example, a leading ERP software provider in Brazil, is locked into its customers’ systems by the complexity of switching to alternative providers. Even in good times, therefore, the business enjoys strong moats. Moreover, it has written its subscription contracts such that pricing automatically moves with inflation each year. Bearing in mind that a good deal of revenue growth can be achieved at near zero marginal cost, it should be well set in this environment.
Amongst the branded FMCG holdings, past experience has shown that dominant companies in this space are typically able to digest some raw material price increases through a combination of direct pricing, pack size adjustments, sales mix optimisation, and flexing of promotional and advertising spend. These companies usually have high gross margins, giving them buffer to manage profitability at operating level. Dominant branded staples companies which operate in fragmented and / or informal markets can also take advantage of inflationary periods to win market share from weaker competitors. Cashed-up balance sheets, scale, bargaining power with suppliers, high margins and pricing power all mean that they are relatively better placed than smaller rivals when times get tough. They may even be able to make acquisitions at attractive valuations. We have seen this acceleration of consolidation play out time and time again with a handful of our holdings.
Our retail holdings, as cost-plus models, usually do quite well with a bit of inflation. For the same reasons as apply to the FMCG players, scale and cash count for a lot in this industry, and can accelerate the transition towards chained, formal retail – the mega-trend we are targeting with these type of investments.
Healthcare names (diagnostics, medical devices, pharma) seem relatively safe places as well during inflation since most of them have limited exposure to inflationary commodities, are essentials (hence enjoy a staple nature of demand), enjoy strong margins and have cash-rich balance sheets.
Nonetheless, taken as a whole, we see inflation as being a manageable problem for our holdings at an operational level, and in some cases may even create opportunities.
