After scrambling to protect portfolios against double-digit inflation, investors now face a period of 'disinflation'. This is where inflation rates fall but remain positive, marking a return to more normal rates of price growth.
UK CPI inflation
The latest Bank of England forecasts suggest inflation will steadily fall over 2024, reaching the government’s 2% target by late 2025.
While we might be on track for our 2% target, geopolitical factors could still pose a risk to this outlook. However, so far, the economic consequences of events in the Middle East have been minimal.
Here’s three UK companies that are better positioned to benefit from lower inflation and could perform well.
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Auto Trader
When purse strings are tight, splashing on a new car can normally wait. The situation, worsened by new car price hikes, has meant more people holding onto cars for longer. This contributed to an 8% fall in used car transactions for Auto Trader last year.
However, improved affordability and lower financing costs should boost the car market going forward. But if inflation proves to be stubborn, Auto Trader’s focus on retailers, rather than private sellers, should help shelter revenues.
When cars aren’t rolling off the forecourt, cutting on marketing spend is a last resort. That defensiveness helped Auto Trader’s revenue increase by 14% last financial year.
Auto Trader makes it easier for customers to buy and sell cars by offering a platform and a range of data services to help sellers get the best price and quickly turn their stock into cash.
The cornerstone of the investment case is Auto Trader’s market dominance and the network effects from its 78 million online visits a month.
Being the online storefront of choice for buyers makes it an indispensable partner for retailers to survive and prosper in a fiercely competitive UK car market.
And as newer entrants like Cazoo have showed us, it’s tough to challenge Auto Trader’s market share.
Being fully online means you don’t have to spend as much to offer your service. This helps feed into healthy operating margins of around 70% and allows profits to convert into cash flow.
That’s helped Auto Trader to pay down debt over the years and transform the health of balance sheet, which now looks very strong.
As well as tailwinds from falling inflation, Auto Trader has structural trends supporting top line growth.
The growth of electric vehicles (EVs) should boost the need for Auto Trader’s data services. Since the EV market is still new and complex, the insights provided will form an important part of retailers sourcing and pricing strategies.
Consumer appetite to complete more of the car buying process online should also allow Auto Trader to sell more additional services in the purchasing journey.
We don’t think Auto Trader’s valuation, which is below its long-term average, reflects the group’s growth potential and its demand. But there are no guarantees. And although the number of subscribing retailer forecourts is steady, there’ still significant pressure on these client’s businesses.
Marks and Spencer’s
Cooling inflation might help boost consumer confidence, and therefore spending. This makes a well-positioned retailer like Marks and Spencer (M&S) an attractive consideration.
While improving consumer confidence benefits all retailers, M&S has specific strengths that set it apart. It emerged as one of Britain’s fastest-growing food grocers last quarter.
M&S also has big opportunities in clothing and home, which currently make up almost a third of its £11.9bn total revenue.
Sales of clothing items offer potential, with recent growth reflecting improved customer perceptions of value, quality and style. Spending has been more subdued with the cost-of-living pressures. However, M&S’s improved brand positioning and design modernisation make it well placed to capitalise on revived spending as inflation eases and sentiment improves.
M&S has also made substantial investments in its value proposition for food. The decision not to pass through the full cost of inflation to customers reduced margins last year. But raising prices less than its rivals boosted volume growth, with the effect being increased sales.
With the groundwork laid to capture a greater share of the nation’s weekly food budget, easing cost inflation should be a boost to profitability over the coming years.
There are risks to keep an eye on though.
A continued preference for lower-value goods could put downward pressure on margins and free cash flow if volume growth begins to stall. This is more likely should the economy slip into a downturn.
That said, operational and strategic improvements mean the business is healthier than it’s been for some time.
Generating more cash and a more robust balance sheet have helped it keep knocking down net debt. This financial stability has allowed M&S to restore its full-year dividend to 3p per share. While the prospective yield of 2.4% might seem modest, the anticipated increase in dividends could appeal to income-focused investors.
This strength has led to a significant recovery in the valuation over the past 12 months, which now sits just above its long-run average.
This still underestimates the group’s growth potential, though economic uncertainties could cause some ups and downs along the way and there are no guarantees.
Softcat
If inflation continues to slow, business cost pressures should ease, and we could see UK interest rates cut in the medium term.
Lower inflation and interest rates can lead to increased business spending on tech. Whether that’s cloud computing, cyber security, new hardware and everything in-between, the likes of Softcat are well positioned to capture that demand.
We particularly like Softcat's focus on small and mid-cap companies, which sets it apart from counterparts who have more enterprise clients. Although smaller businesses have struggled recently, they stand to benefit from lower inflation and interest rates.
Softcat’s also positioned to benefit from the rise of generative artificial intelligence (Gen-AI). The complex implementation of Gen-AI could increase demand for value-added resellers (VARs). Unlike competitors who only source solutions, Softcat also provides consulting services on AI adoption which it can charge a premium for.
Softcat acts as a middleman between tech firms and customers. Businesses get a one-stop shop for their IT needs and tech providers can outsource sales and customer service. By leveraging its size, Softcat negotiates discounts and profits from selling services and hardware at a markup. This strategy helps Softcat thrive as technology spending grows and more companies look to outsource their IT sourcing.
Softcat's business model enables growth at high margins with minimal capital expenditure, resulting in healthy free cash flow and a strong balance sheet. But with further room for growth and a history of compounding cash profits at 18% over the last decade, investors have to pay up for its qualities. The current valuation of 26.5 times expected earnings is above its long-term average and could make it more susceptible to some volatility.
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