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case—1970s stagflation—are you confident that these can be compounders over the next 10 years in such an environment? Romick: It depends on the company. In some cases, you have more comfort level than in others.

low prices relative to the competition for Wal-Mart customers, which will benefit them over the longer term with respect to cash flow. It could also increase transportation costs for their competitors. With Budweiser, I think that there’s a lot more moving parts in terms of commodity exposure—agricultural products, barley, wheat, etc. But they’re pretty well hedged for the next couple of years, so there’s less risk now, but higher risk down the road. Beer sales have tracked closely to what’s happening at the pump. If gas prices increase a lot, sales of six packs of these low-price beers decline. So a weaker economy will have an impact, as would higher commodity prices. In such a scenario, both sales and margins could get squeezed.
Inker: You’ve got to be careful asking about a

Johnson & Johnson’s margins are at an all-time high, and its P/E is at an all-time low. But its operating margin is about 60% higher than it was two decades ago. I do not currently have conviction that margins will not contract some. It’s a business that has been fairly well optimized. I think there is more risk there. But Kraft’s operating margin reflects the inverse. We’ve seen a decline in margins from two decades ago—running well below where they had peaked. So it could be a different case for Kraft. Certainly, they have more room to improve their business, I would argue, than Johnson & Johnson has. I’m less worried about a Wal-Mart, because Wal-Mart is not one of those companies that is a margin-taker. A margin-taker is a company that keeps cost savings for themselves through expanded margins, rather than passing on the savings to their customers. Wal-Mart has been unusually consistent in their margin over time by taking savings and returning those savings to their customers in the form of lower prices, so that they continue to attract people to their stores. There was an analyst report not too long ago about Wal-Mart and what they’re proposing to do with their suppliers. They’ve gone to their largest vendors and said, “We think that we can manage your supply chain logistics better than you.” This analyst came out with a report and made a bullish call on Wal-Mart because it would benefit Wal-Mart’s margins. Well, it’s the right bullish call but for the wrong reasons. I would argue that whatever cost savings they’ll capture won’t flow through Wal-Mart’s margins; it’ll be recycled in the form of lower prices. If they can do this successfully, it will just mean continued

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repeat of the 1970s. In the 1970s and early 1980s, the Kelloggs of this world saw declining margins because they didn’t react to higher input costs by raising their prices. It’s not entirely clear why they chose not to. They could have done it. They seemed to think that it was beneath them. They don’t think that way anymore. When agricultural prices increased in 2007 and 2008, food companies responded quickly. Again, we believe that high-quality companies should be in a decent position to defend their margins in the event of inflation. They can’t necessarily do it perfectly, but there’s no particular reason to believe that these guys are hurt worse than others. There are some reasons to believe they may be able to hold on to their margins. K
Ryan Leggio is a mutual fund analyst with Morningstar.

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