Sagflation to Cause Consumer Company Shakeout?

"The cumulative effect of these management decisions to fund low-level return projects is a glut of assets, highlighted by overcapacity in industries like the restaurant industry."
                                                                  - Liquidity Trap, June 26 posting.

"Everyone is talking about raising prices."
                                                                  - Manny Chirico, CEO of Phillips Van Heusen quoted in WSJ

Industries selling directly to the U.S. consumer are increasingly feeling pinched between rising costs and an inability to raise prices. Companies appear to be reaching a pressure point in which they are willing to risk raising prices, and potential slowing sales, in order to maintain margins. Companies have been trying to maintain net margins through cost rationalizations, including outsourcing, lay-offs, and debt restructuring. Offsetting these efforts are rising commodity prices and an outlook of potentially increasing benefit costs, increasing regulations, and higher taxes. Weak consumer purchasing and a crowded competitive landscape have largely neutered price increases, in fact causing many companies to offer on-going price concessions as highlighted in the September release of NFIB Small Business Economic Trends.

I expect to see stronger companies successfully pass along higher costs and maintain overall returns of the business. Stronger businesses are typically well managed, offer higher value products and services, and are positioned in less competitive niches. Assuming economic activity remains flattish, I expect to see weaker companies without clear advantages falter and retreat. Put another way, segments in which there is over-capacity due to over investment spending likely produce tepid sales and declining margins until the weaker players are shaken out.

This analysis suggests that 2011 could produce a painful shakeout in the consumer segments of the economy. It also suggests that the surviving businesses should benefit in a few years from less competitive pressures, more growth opportunities, and more pricing power once this shakeout has occurred. Thus I believe, in general, consumer companies are poor investments in the near-term but could offer very attractive returns in the mid-to-long term.

How does this outlook weave into my sagflation theme? I continue to believe in this environment inflation starts deeper in the supply chain and eventually moves up. The CPI may not accelerate in 2011, but the PPI likely does, and thus my investments in companies deeper in the supply chain that can pass along price increase, like HUN and SOLR. Additionally, the inflationary pressure is likely not evenly distributed in the economy, instead bubbling up in specific asset classes and generally causing greater price instability.

Proof points for which I will watch to show a shake-out is occurring in consumer companies include rising bankruptcies and acquisition activity. While this cleansing process plays out I plan to generally avoid consumer companies that are primarily focused domestically.