Companies with pricing power hold the key for investors should inflation continue to rise as expected over the coming year, according to Anthony Cross, co-manager of the Liontrust Special Situations fund. 
Recent figures from the Bank of England shows inflation expectations peaking at 2.7 per cent in the fourth quarter of 2017, up from the previous forecast of 2 per cent made in August.
This week the National Institute of Economic and Social Research published forecasts which included a prediction of around 4 per cent consumer price index (CPI) inflation by the second half of 2017.
Performance of inflation since 1992
Source: Office for National Statistics
If inflation were to rise above 4 per cent, it would be the first time since 2012, as the above graph shows.
This change in expectation has largely been thanks to the rising cost of imports following the fall in the value of sterling after the EU referendum.
This sharp increase in the cost of imports could cause a dilemma for companies, as demonstrated recently by the public spat between consumer firm Unilever and supermarket giant Tesco.
Cross (pictured) said: “The brief absence of Marmite from Tesco’s shelves in October brought to public attention the battle between consumer goods companies (in this case Unilever) and retailers over who would foot the bill of increased ingredient import costs.
“While this match up looks to be a score draw, with Tesco restocking Unilever products but not yet implementing the price increase Unilever has demanded, Morrisons has relented to the pressure, raising the price of Marmite by 12.5 per cent and hiking the prices of over 90 other Unilever products.”
Unilever is the fourth largest holding in the Liontrust Special Situations fund, representing 3.77 per cent of the portfolio.
“Unilever (whose other brands include Dove, Lynx, and Ben & Jerry’s) is a stock we hold in our funds. Together with other consumer goods and beverages holdings like Diageo (Smirnoff, Guinness and Johnnie Walker) and Reckitt Benckiser (Nurofen, Strepsils and Dettol), we believe it has a significant amount of value associated with its brands.”
This, he says, is the simplest way for a company to possess pricing power, through the value of its brands. “These brands play no small part in conferring these stocks with pricing power and Economic Advantage.”
It is easy to contrast this with stocks which have little pricing power, as the below graph shows, over the course of the year, retailers have dramatically underperformed the companies in the consumer goods sector.
Performance of indices in 2016
Source: FE Analytics
“Although Tesco’s huge market position seems to have given it some leverage in its Unilever negotiations, retailers in general are not in a strong position to cope with imported inflation, particularly if they are selling commoditised products or other non-premium goods,” he said.
“For example, disposable-fashion retailer Primark (via its parent group Associated British Foods) has already been forced to warn its investors that current exchange rates will result in an increase in input prices which it will be unable to pass onto consumers (unlike those buying Marmite in Morrisons), thus hurting its gross margin.”
Cross added that the above data “clearly shows that the UK’s FTSE General Retailers sector has already weakened to reflect the increased cost of importing goods.”
It is clear, therefore, that investors should focus on companies with pricing power, with Cross adding “we are already starting to see stock market fault lines developing between those companies that have it and those that don’t”.
A look at the top 10 companies within his fund shows belief of this, with the likes of drinks maker Diageo and pharmaceutical giants GlaxoSmithKline and AstraZeneca among its largest holdings.
The five crown-rated Liontrust Special Situations fund, which Cross runs with fellow FE Alpha Manager Julian Fosh, has performed exceptionally over the last decade and is the second best performer over the period in the IA UK All Companies sector.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
As the above graph shows, the £2.1bn fund has returned 220.43 per cent over the last decade, while the FTSE All Share and UK All Companies sector have returned 61.50 and 67.35 per cent respectively.
“A key tenet of our investment process is the importance of barriers to competition,” Cross said.
“We have moulded our approach around the identification of characteristics which we believe allow companies to sustain profits in the face of competitive threats.
“It is this theoretical ability to generate a higher than average level of profitability for longer than expected which we refer to as Economic Advantage.”
The fund, which has also been a top quartile performer over one, three and five years, currently yields 1.88 per cent and has an ongoing charges figure of 0.88 per cent.