Greg Ip recently wrote in the Wall Street Journal (emphasis mine):
If Trump’s effort to remove Lisa Cook for cause succeeds, and perhaps even if it doesn’t, this week will go down as one of the most consequential for financial markets in decades.
It could mark the end of the Federal Reserve’s independence from White House control, which it effectively obtained in 1951. As a result, inflation is likely to be higher and more volatile than in the decades before 2020.
Investors aren’t pricing in such a scenario.
I don’t know if this is true or not Journalists have a predisposition to hyperbole, after all. But it seems plausible.
Regardless, Dan and I remain “optimistic but paranoid.” We hope for the best but prepare for the worst. We’re always thinking about inflation, as we explained in How We Prepare for Anything, but Nothing in Particular. The prospect Ip raises doesn’t change our approach, but has got me thinking about what makes a business resilient to inflation. Now that its been five years since COVID and the ensuing inflation, its a wonderful time to study up on it.
Why Is Inflation Bad?
In January 2021 I wrote Playing With Fire, which referenced Buffett’s 1977 piece in Fortune Magazine to explain how “inflation swindles the equity investor.”
Imagine a business that earns a $25 profit by employing $100 of capital. That’s a 25% return on invested capital (ROIC), which is solidly above-average. Then, the price level doubles. To maintain its real purchasing power, the business must double nominal profits. So, it doubles its prices. Voila!
Not so fast. The company’s suppliers will have raised their prices too. As a result, the company will need to double its nominal investment in working capital (inventory, payables, receivables) to support the same unit volume. Eventually, the company will also need to replace its long-lived fixed assets (property, plant, equipment), which will also have doubled in price.
So, the company’s capital will increase from $100 to $200, and profits will increase from $25 to $50. Real purchasing power and ROIC will remain unchanged.
The swindle? The company’s investors were forced to invest an additional $100 of capital merely to maintain the purchasing power of their profits. $100 of capital was consumed with no real return to show for it. No one benefits — not investors, laborers, or society -- when inflation consumes capital. That’s why Warren Buffett called inflation a “gigantic corporate tapeworm.”
Inflation requires business owners to invest incremental capital merely to maintain unit volumes. And that is if they can pass along prices increases to maintain their margins without losing unit volume. The increase in capital invested might require bank loans, debt issuance, equity issuance. It could also be funded from retained earnings and eat into what would otherwise be free cash flow available for dividends and buybacks.
Degrees Of Resiliency
In Playing With Fire I went on to explain that some businesses were more susceptible to inflation that others. One rule of thumb is that the more capital intensive a business is, the more it is susceptible to inflation. I’d like to put a finer point on that today.
I became fascinated with the timing of price increases during the recent spell of inflation. Some businesses can raise prices before their costs rise, which lightens the blow.
Commodities
Commodity businesses get the benefit of price increases immediately. That’s why conventional wisdom holds that they are excellent inflation hedges. The problem is that commodity businesses also tend to be capital intensive and low ROIC. Eventually mining equipment needs to be replaced, at a substantial higher cost. Same for drill rigs and oil wells. When these expenses come due, the abnormally high ROIC caused by inflated commodity prices disappears.
Commodity businesses benefit from inflation, but only in the short term, and only because their selling prices rise faster than their input prices. Inflation eventually catches up with them.
The good news is that commodity businesses should be flush with cash from the initial spike in selling prices when the bill for maintenance comes due.
Gold miners are a good example. Initially, when the price of gold futures spikes, they earn above-average profits. But inevitability, and quicker than they’d hope, the cost to mine gold — the all-in sustaining cost (AISC) — rises commensurately, or even more.
The longer a company’s assets last, the longer they can kick this can down the road. Long-lived mines, like Core Natural Resources’ Pennsylvania Mining Complex or Saudi Aramco’s Ghawar Field can use infrastructure built with old dollars to earn new, inflated dollars. Rapidly depleting assets like the Permian Basin have a shorter investment cycle, making them less resilient to inflation.
Long-Lived Assets
Real estate businesses and railroads have very long lived assets. They’re typically depreciated over 40 years, or 2.5% per year. The problem is that these businesses can’t usually pass through inflationary price hikes immediately. They have to work them in over time, suffering some margin and ROIC compression in the interim.
Certain utility and infrastructure assets, like the ones Brookfield owns, have pricing provisions indexed to inflation. Examples include electric and water utilities, hydroelectric dams, electric transmission lines, ports and airports, pipelines, telecom towers, spectrum, and fiberoptic lines. These assets don’t always have long term leases with inflation-linked price escalators, but its not uncommon.
Businesses with long lived assets typically have overstated net income. Depreciation charges are in old dollars and are less than the current replacement cost spent on capex. Free cash flow is a better measure of earnings power.
Pricing Power
Pricing power is the “holy grail” of business qualities. Its the ability to increase prices without losing unit volume. Very few businesses have it. It is also easily abused, ruining it.
Luxury companies like Ferrari, Hermes, and Rolex have it. They make timeless products that have changed little over the decades. They carefully control supply to remain below demand. Enzo Ferrari once explained, “Ferrari will always deliver one less car than the market demands.” People desire these luxury products as much or more as their price increases, allowing these luxury brands to weather inflation.
The tradeoff is that luxury businesses cannot meaningfully increase unit volume without jeopardizing their pricing power. They can also be hamstrung by currency movements, which can be exacerbated by inflation.
Rolex wants a Submariner in New York to cost the same as one in London, Cape Town, Hong Kong, and Sydney. But they don’t want to be adjusting prices every day or jacking up prices in local currency (when local wages are flat) just because the local currency depreciated. If meaningful price differentials exist, a cottage industry of personal shoppers notices, flying around the world to arbitrage the prices for their customers. The same goes for Hermes, and, to a lesser degree, Ferrari. As a result, luxury companies may not increase prices 1:1 with local currency inflation.
See’s Candy is a good example of a company with pricing power. When Berkshire acquired it in 1972 they were producing 16 million pounds of candy per year and earning about $4 million, pre-tax. In 2007, Berkshire reported that See’s was producing 31 million pounds of candy per year and earning $82 million pre-tax. Volume grew at a 1.9% CAGR while profits grew at a 9.0% CAGR. This implies pricing of about 7% per year, though in reality it was probably a little less as operating leverage probably drove some margin expansion. Inflation averaged 5.4% over that period, so pricing was likely a little ahead. Buffett has mentioned that this required almost no retained earnings, making See’s an example of an ideal business.
FICO is an example of a business that seems to have recently discovered it had vast untapped pricing power. FICO is basically licenses mathematical formula that takes data from companies like Experian, TransUnion, and Equifax and produces a credit score. It the industry-standard for credit reports and even written into legislation, making it sticky. In 2023 FICO charged $0.60 to $2.75 per score under a tiered pricing system. In 2024 they increased prices to $3.50 and in 2025 increased prices again to $4.95.
Credit scores are required, mission-critical pieces of the credit underwriting process. Even at $4.95, they are cheap relative to the total cost of underwriting and money at risk.
However, just because you can increase prices doesn’t mean you should. Or, shouldn’t all at once. FICO’s actions have drawn ire from the mortgage industry, which is in a downturn. Congressmen, Senators, and the Consumer Financial Protection Bureau (CFPB) have been vocal critics as well. Last month, Fannie Mae and Freddie Mac’s regulator said VantageScore could be used to underwrite home loans, according to the WSJ. That may begin to weigh on FICO’s volume and pricing power.
The bottom line on pricing power is that it is a wonderful thing to have, whether there is inflation or not. It is incredibly hard to develop, as the luxury brands have shown, and easy to abuse, as FICO demonstrated. See’s results show that pricing power in excess of inflation can create tremendous wealth, but it is a game of inches in any given year.
Take Rate Businesses
Trying to decide when and how much to raise prices is a tough game. I like take rate businesses because they don’t have to make though tough calls. They earn a percentage of whatever flows through their “pipes.” These could be literal pipes, in the case of a pipeline, or a toll bridge. Even better are asset-light “pipes”, like Amex or Visa’s credit card network. As the supply of money increases, so does volume on these networks and Amex and Visa’s cut. Since credit card networks are digital, there’s little to no maintenance capex required. The incremental profit largely falls to the bottom line.
Asset managers, like T. Rowe Price, Brookfield, and KKR also benefit from this. Moody’s and S&P too. As inflation inflates asset prices, they earn fees on those higher prices. These types of businesses have minimal hard assets and almost no capex. They do, however, have substantial labor costs which do rise with inflation. All in all they are very resilient to inflation.
Take-rate businesses are easier to manager, at least from a pricing perspective, than businesses with pricing power because the price increase take effect automatically. Revenues tend to rise almost immediately when inflation hits. Wages increase on a 6-12 month lag, giving them a buffer.
Insurance
One of the places we saw the most dramatic inflation effects what in auto insurance. Auto insurance is underwritten every six month, making it short tail. Underwriters need to forecast the frequency and magnitude of accidents and the cost of repair. The cost of repair has an imbedded inflation assumption. In 2021 the auto insurers realized that their inflation assumptions were too low as they began losing money.
The short-tail nature of auto insurance allowed them to quickly right the ship. The industry pushed through prices increases, which were begrudgingly accepted by drivers who are legally required to be insured. Profits are now at all time highs, but there was an uncomfortable lag for equity investors.
We’re seeing a somewhat similar dynamic today in health insurance, which is underwritten annually. Health insurers underestimated the quantity of health services people would use in 2025 and are losing money. The industry will likely push through price increases in 2026, perhaps losing a little volume (but not much) and be back to record profits in a year or two.
One of the best places to profit from inflation proved to be insurance brokers like Brown & Brown, Marsh McLennan, Aon, Willis Towers Watson, and Arthur J. Gallagher & Co. These are capital-light take-rate businesses who benefitted as insurers increased prices and customers, looking for a deal, leaned on their brokers to help them navigate a confusing and rapidly changing landscape.
High ROIC and Negative Working Capital Businesses
AutoZone and O’Reilly are wonderful and unusual businesses because they have pricing power, due to rational industry pricing and non-discretionary demand, in addition to a high ROIC due to negative working capital.
Here’s what that means, practically speaking. When inflation hits and auto parts suppliers raise prices, AutoZone and O’Reilly immediately pass along the price increase to end consumers. They don’t lose volume because paying a few percent more for a $50-100 part is still a lot cheaper than losing your job or buying a new car for $40k.
Another reason AutoZone and O’Reilly can pass through price increases immediately is because they offer excellent service, with most parts deliverable within 2 hours. That’s critical to mechanic trying to turn cars in his few bays. Their focus on service quality and speed insulates them from lower-priced competition.
The downside of this focus on speed is that they need to carry a ton of inventory. Normally this would weigh on ROIC, especially during inflation when inventory needs to be replenished at higher prices. To combat this, AutoZone and O’Reilly use their bargaining power to extract ultra-long payment terms from their suppliers. Their suppliers, in essence, finance their inventory for them. Suppliers factor their receivables with banks, laying off risk in the system.
The end result is that AutoZone and O’Reilly have negative working capital. They get the benefits of immediate price increases, like a commodity company, but with minimal capital intensity. Unlike most businesses, the don’t have to invest ahead of time in inventory. They can sell it at the new, inflated price, before they pay for it themselves.
McKesson also has negative working capital, non-discretionary demand, and a rational industry structure. It operates more like a take-rate business, with 1-2% margins. It benefits as pharma companies increase prices and new drug discoveries increase volumes.
Costco also has negative working capital, which increases its ROIC. It is known as a low-cost producer, which drives volume to it when consumers are stressed by inflation and looking for deals, as they are now. The result has been a lot of valuable, high ROIC growth for Costco since 2020.
Looking Ahead
Howard Marks said something to the effect of “We’re always headed toward a recession, we just don’t know when it will arrive.” Its the same with inflation, though perhaps inflation is slightly more predictable.
At EPC, our ethos is to prepare, not predict. We always want to be prepared for inflation. We want to at least be resilient, and benefit if we can.
What worked between 2020 and 2025 may not be exactly what works again, but should offer some clues. The winners had several common characteristics:
non-discretionary demand;
negative or minimal working capital;
pricing power;
asset light or long-lived assets with inflation-index leases;
take rate pricing mechanism;
low cost producer.
These are wonderful business qualities to have, inflation or not. Building a portfolio that is resilient to inflation does not require making a bold bet on the timing and magnitude of inflation.
Valuation also matters. AutoZone briefly traded for 10x earnings during the March 2020 COVID crash. Today its in the high 20s, which is much more reasonable and fair, but not nearly as obvious of a bargain. Costco and FICO both trade for north of 50x earnings (and that’s with FICO about 40% off its highs). These are priced for perfection, their inflation resiliency more than fully priced in.
Investors who want asymmetric returns if (or when) inflation rears its head again will have to look farther afield. NRP continues to trade for less than 10x earnings, has minimal costs (capital, labor, or otherwise), and its earnings are directly tied to commodities prices. It should do well if inflation picks up.
Brookfield is also well positions with an attractive valuation, take-rate business model, and long-lived mission-critical infrastructure assets with inflation-indexed revenue.
Watches Of Switzerland has negative working capital and operates like take-rate business on US and UK Rolex sales. Rolex is almost sure to increase prices at or in-line with inflation, especially relative to the Swiss Franc and gold. They may not increase prices in lockstep with inflation, though. Yet WOSG trades for 10x earnings.
Auto dealers are also of interest, trading for about 10x earnings. The big public companies are slowly consolidating a large, stable, and highly fragmented industry. OEMs will have to increase prices to offset inflation, which will flow through to dealers. Dealers finance their inventory with OEM-subsidized floor-plan financing, increasing ROIC.
Tariffs affect businesses like any other increase in costs, whether due to general inflation, a tax increase, or levy. If the cost of a product’s raw materials or inputs goes up because of tariffs, working capital increases for the same unit volume. The company will have to retain more profits and reinvest into working capital to support the same unit volume. Or debt or equity will have to be raised. This detracts from dividends, buybacks, or growth capex.
If the business can pass the price increase on, it will eventually get back to its base margins and ROIC. Most companies cannot push through the full price increase in one go. That means the cost pressure on inputs will continue to trickle in, as will price hikes on the final product. During this period margins and ROIC may be depressed.
This process will reward low cost producers. Businesses with bargaining power can push back on their suppliers and force them to eat more of the tariffs. They can pass the price savings on to consumers, who, weary from inflation, will be looking for value. In this sense, the big are likely to get bigger. We like to look at relative market share versus absolute to gauge the competitive advantage from scale. A company that has 2-3x the market share of the next largest competitor, like Alimentation Couche-Tard or AutoZone, can create more relative value for consumers in this situation than those in a consolidated oligopoly like McKesson or Davita.
The market tends to reward companies with rising ROICs with higher valuations, as it should. Investors need to beware of how inflation will the timing of increased profits and capital employed. Commodity companies will see profits rise before costs, but eventually costs raise too and margins and ROIC even out. Buying into elevated ROICs in commodity companies may be dangerous and akin to buying at the top of the cycle. The effect is similar but less severe at companies with long-lived assets. The best companies to buy, inflation or not, are ones that can take price up front (one way or another) but who have little to no capital employed.
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