The inflation-proof shares fund managers are backing

The key ingredient to combat higher inflation is to target shares that possess pricing power. 

Inflation has been bubbling beneath the surface for several months, but is now at the forefront of investors’ minds.

Earlier this month, legendary investor Warren Buffett and star fund manager Bill Ackman raised the alarm over the potential threat of inflation rearing its ugly head in the coming months and years.

Buffett commented that the US economy is “red hot” following the pandemic recovery. He noted that a number of his portfolio companies across a range of sectors are seeing substantial inflation coming through, with one driver being consumers splashing the cash as lockdown restrictions ease.

• Invest with ii: Top Investment Funds | Index Tracker Funds | FTSE Tracker Funds

Ackman, meanwhile, is mindful of the risk of the US economy overheating if interest rates remain at low levels and wage growth increases. Inflation in the US hit a 13-year high in April, with its Consumer Price Index rising by 4.2%.

In the UK, the Consumer Price Index notably jumped in April, from 0.7% to 1.5%. Andrew Bailey, governor of the Bank of England, said this was not a surprise and pointed out that the bank expects inflation to rise above 2.5% this year and then fall.

But some investors disagree, and fear inflation will rise much higher to do the heavy lifting to reduce the huge government borrowing that has taken place in response to the Covid-19 pandemic.

• Why Warren Buffett just rang the alarm on inflation 
• How to play and profit from the commodities boom 
• 14 investment trusts to inflation-proof your portfolio

Shares to beat rising inflation 

Rising levels of inflation are bad news for certain parts of the equity market - most notably companies that are price-takers rather than price-makers. Cyclical businesses that compete on price, such as retailers, will struggle.

Therefore, it makes sense to target shares that possess pricing power. Anthony Cross, fund manager of Liontrust Special Situations, one of interactive investor’s Super 60 choices, focuses on intellectual property – companies with barriers to competition and pricing power.

In an interview last week for interactive investor’s Funds Fan podcast, Cross said such qualities give those “businesses an advantage versus your average business in the stock market”.

Cross picked out engineering companies as having “strong intellectual property” and “pricing power”. The fund owns Spirax Sarco (LSE:SPX), Spectris (LSE:SXS) and Renishaw (LSE:RSW).

Diageo (LSE:DGE) and Unilever (LSE:ULVR) were also named by Cross as other inflation hedges. He points out that both “have decades of experience in being able to adjust prices in line with inflation”.

• Funds Fan: equity funds in favour and Liontrust Special Situations interview 
• An inflation survival plan for investors

Christopher Rossbach, chief investment officer at J.Stern & Co, also highlightst Diageo. “With bars and restaurants now reopening, and consumers’ clear desire for social occasions and group gatherings after so many months of social distancing and lockdowns, we expect the demand for premium spirits will be buoyant.

“We are confident that Diageo will also be able to protect its margins through price increases should inflation become a cost pressure.” 

Visa (NYSE:V) and Mastercard (NYSE:MA) also provide a hedge for investors against inflation, he says. Rossbach explains that as payment networks earn revenues based on the prices of the transactions that they process, any rise in consumer prices will correspond with an increase in revenue for them.

He adds: “These companies already have very high incremental margins embedded in their business models, so the extra revenue generated would exceed the corresponding costs. Therefore, both companies can expand margins and grow revenues in an inflationary environment.”  

Job Curtis, fund manager of the City of London (LSE:CTY) investment trust, which is in interactive investor’s Super 60 list, namedthree sectors that he believes are well placed if inflation takes off.

The first is utilities. Curtis points out that companies in this sector “have the ability to move prices with inflation under the regimes set for them by regulators”. City of London has 7.7% of its portfolio in utilities with stakes in National Grid (LSE:NG), SSE (LSE:SSE), Severn Trent (LSE:SVT), United Utilities (LSE:UU) and Pennon (LSE:PNN).

• Check out our award-winning stocks and shares Isa
• Bill Ackman: I think this could be the Black Swan event of 2021

The second sector Curtis highlights is miners. He notes that “supply can be slow to respond to increased demand, such as from infrastructure spending or electrification, leading to price increases for commodities such as iron ore and copper”. City of London has 7.6% of its portfolio in mining with holdings in Rio Tinto (LSE:RIO), BHP (LSE:BHP) and Anglo American (LSE:AAL).

Third, Curtis says that supermarkets should be able to pass on food and essential goods' inflation to customers with price increases. City of London has 3.4% of its portfolio in food retailing with positions in Tesco (LSE:TSCO) and WM Morrison (LSE:MRW).

Curtis adds: “Overall, elevated inflation would be challenging for many companies, but those with pricing power should be best able to cope.”

Proven pricing power was also named by Simon Young, fund manager ofAXA Framlington UK Equity Income, as the key attribute in finding companies that can “shield earnings from inflation, should it pick up in a more sustained manner”.

Young notes that accounting software provider Sage (LSE:SGE) and fantasy miniatures designer, producer and retailer Games Workshop (LSE:GAW) have “shown the ability to raise prices ahead of inflation for a number of years, cushioning the effect of inflation on their earnings”.