Margins and Your Money

This last week I had the luxury of spending some time in Northern Wisconsin at my parent’s cottage. One of our traditions each year is attending the local 4th of July parade. We park at a local brew pub that serves bloody marys and screwdrivers. After standing in line for a time, I was able to buy one, but I could not help noticing the price had gone up considerably (almost double) from the prior year. If the beverage was for me, I do not think I would have bought it, but buying mom a screwdriver seems like a small price to pay even with the price increases. (It really was for mom!)

The owner of the establishment was meandering about, so I asked him about the price change. He said that he had been absorbing the cost increases as much as he could to keep the business going, but he had reached a point that he could no longer do that and needed to pass the price changes on to the consumer. This is what we will likely start to see in the markets in the coming quarters.

Consumers and price increases

As we approach the period when publicly traded companies begin to report earnings and set expectations for the future, much of the conversation is going to be around which companies can pass on those prices and which cannot. Will consumers still decide to purchase the product in question, or will they use their money for something else?

I am sure each of us has started to look at those tradeoffs or will from time to time in the future.

The market for its part has priced in some amount of margin pressure and uncertainty, but paradoxically, the expectations for earnings only recently started to reflect those changes.

The chart below illustrates what we have seen priced into expectations. The price to earnings ratio, which is simply a reflection of how much investors will pay for each dollar of earnings, has priced in a fair amount of pressure on earnings. At the start of the year, the market was valuing a dollar of earnings at a price to earnings multiple or PE of 21.5x. This reflected at the time a much different business situation than we find ourselves in today. The market is currently pricing in a fair amount of uncertainty on what earnings might be going forward in terms of a lower price to earnings ratio. So far this year that multiple that investors are willing to pay has declined to a historically low 15.9x as of the end of June. This is roughly 10% below the average PE in more stable times.

The part that is difficult to gauge is what the E, or the earnings, are going to be and does the lower multiple factor in what we could see in terms of businesses passing on price increases and consumers accepting them or not. The next few quarters will tell us a lot about what the actual earnings will be and whether the PE the market set is factoring in enough of that tension between prices and earnings.

In the meantime, when we aren’t enjoying pricey screwdrivers at summertime parades, we continue to focus our investment strategy on those managers and companies we believe have the right mix of expected earnings, valuations and margins to position portfolios for this reporting season that is coming.