Pricing power: a growing differentiator among European equities

The global energy supply crunch triggered by the ongoing US-Iran conflict is evolving into a broader inflationary shock, which may persist longer than markets currently anticipate. As a net energy importer with dwindling supplies, Europe is particularly sensitive to energy price hikes, and core inflation has already started to surprise on the upside. This creeping inflationary pressure could drive input costs higher and test European companies’ pricing power and ability to deliver more value to customers with less.

On the face of it, this could be bad news for European equities all round, but the reality is that inflation does not affect all businesses equally, and we see this environment as a great opportunity to “lean into” mispriced stocks with strong balance sheets. For some companies, higher input costs are a direct margin squeeze, but for others, inflation may raise the returns they can generate and may improve their value proposition for customers.

Mispricing opportunities

With markets tending to apply an inflation discount uniformly, the key question for investors is which companies are being mispriced, either because the market is treating them as overly vulnerable to inflation or is ignoring the fact that they can, to an extent, benefit from inflation despite rising prices. As such, we favour companies that have stronger pricing power or can gain market share amid persistent inflation. In contrast, we are rotating away from companies that are less insulated from higher input costs.

Importantly, we are finding investment opportunities across a range of sectors, with notable examples including:

• A large supermarket chain and retailer, which has already adapted to a difficult environment for food distribution by sharpening its customer proposition around price, range and convenience — a crucial advantage in an inflationary environment. Food is non-discretionary, but shopping behaviour is highly sensitive to trust and perceived value. When households are squeezed, consumers are more likely to consolidate spending with retailers that offer reliability, competitive pricing and broad choice. This retailer’s scale gives it purchasing advantages, while its improved execution has helped it defend price perception and gain market share.
• A pivotal electrical distributor, which sells more than one million electrical products and components to contractors, industrial customers and building-related end markets. In our view, the company should be able to pass through higher product prices more effectively than many businesses, given the essential nature of its products, the complexity of its offering and its role as a convenient one-stop shop for contractors. In addition, the company’s long-term volume opportunity is attractive. Electrical content is rising across buildings and infrastructure as customers adopt heat pumps, EV charging, solar batteries, connected systems, automation and more advanced building controls. Europe’s drive to improve energy efficiency and reduce reliance on imported energy should only accelerate this trend.
• A leading provider of insulation, which can potentially help customers adapt to a higher-cost energy environment. Its product range improves building energy efficiency while also offering strong fire-resistant properties. This matters because buildings account for a large share of Europe’s energy consumption. Insulating buildings is one of the most direct ways to lower energy bills, reduce the impact of climate change and protect consumers and businesses from the vagaries of imported energy. The company should also benefit from tighter building standards, fire-safety regulations, renovation activity and the broader push to make European housing and infrastructure more energy efficient. The business has a strong balance sheet, which is valuable in a higher-interest-rate environment and gives it the flexibility to keep investing through the cycle. While not immune to weaker construction markets, we think the company is well positioned for a world in which energy efficiency and building safety become less of a discretionary upgrade and more of an economic necessity.

The value of contrarian thinking

These examples highlight why we think Europe’s inflation story is not uniformly bad news for active investors. In our experience, it is possible to find attractive bottom-up investments with a clear potential to outperform peers despite the more challenged macro environment. Inflation creates pressure, but it also creates dispersion. Select retail stocks can benefit from consumers becoming more value-conscious; disruptors can benefit from customers seeking lower-cost solutions, and companies that provide products or services that are essential to Europe’s structural transformation can profit from lasting pricing power. In each case, the common thread is not immunity from inflation, but an ability to help customers adapt to a higher-cost world and remain competitive relative to peers.