As Costs Spike, Will Companies Raise Prices?

Prices of commodities like cotton, wheat, corn, gasoline, copper, and oil are skyrocketing. The reasons vary but in general there is growing demand for them in developing nations and traders are betting on a falling dollar and rising commodity prices. The combination of real demand exceeding supply and massive trading bets is pushing up prices in dollar terms. 

The problem facing companies that use these commodities in their products is whether to pass those cost increases on to their customers. If they do, they risk losing sales to competitors who decide to eat the cost increases and keep their prices where they are to attract cash-starved American customers in a weak economy.

The problem is that if these companies do not raise prices, they will disappoint investors when they report lower than expected profits. So companies are struggling with how best to respond. Their choices could sink the economy into stagflation on steroids.

Evidence of commodities price spikes is compelling, even as general inflation statistics -- the October CPI was up 0.6%, the lowest rate in 53 years -- suggest prices are flat in the U.S.. And a huge factor in that rise in commodity prices has been demand from China. Food inflation there is soaring at 10%, according to Bloomberg, so China is raising interest rates in an effort to put the brakes on those price increase.

How Can General Inflation Be Low When So Many Commodity Prices Are Spiking?

Meanwhile, the price increases in many commodities have been much greater than the general level of U.S. inflation. Bloomberg Businessweek reports the following examples:

• Raw materials prices. The Thomson Reuters/Jefferies CRB Index of 19 raw materials has risen 15.3% percent in the past five months, led by agriculture commodities. However, in the last 10 days, that index has lost 6.6% as investors anticipate slower economic growth in China;
• Corn futures for March delivery spiked 56% from June 30 to a Nov. 4 peak of $6.04 per bushel. Between then and Nov. 22, those corn futures have slipped 12.3%;
• Wheat futures climbed 28.3% since June 2010;
• Sugar prices skyrocketed 60% during that time;
• Cotton futures for March delivery rose 51.6%;
• Crude oil inched up 5.2%; and
• Copper prices increased 26.4%.

Not all companies are choosing to eat those cost increases. Those with strong brand recognition -- General Mills (GIS) and Crocs (CROX) shoes -- will raise prices in 2011, according to analysts.

Clothing and footwear makers are not going to be able to pass the rising costs of raw materials on to their customers. That's because of a decade-long trend of declining prices due to greater rivalry among competitors and the opening of new retail channels leading to aggressive price cuts. Between 1998 and 2008, clothing and footwear prices fell 10% and 4% respectively, according to Bloomberg Businessweek. And that trend is not likely to reverse in the middle of a moribund economy.

Different clothing suppliers are dealing with the rising costs of raw materials -- like rayon and cotton -- differently. Some -- such as V.F. Corp. (VFC), Nike (NKE), Polo Ralph Lauren (RL), and Phillips-Van Heusen (PVH) -- refuse to pay their suppliers the full rise in their costs.

Although the rayon costs have risen due to higher oil prices (rayon is derived from oil), these retailers are going to shift their product mix to favor the higher margin rayon-based apparel instead of selling pure cotton items -- whose costs have risen much more. Meanwhile, retailers that source for their own labels -- like Gap (GPS) and J.C. Penney (JCP) -- are likely to pay their Chinese suppliers as much as 30% more as a result of rising cotton costs.

Food makers are trying to avoid price increases by selling lower quality products that cost less. For example, in the beef industry, there is a shift to less expensive cuts like flank steaks, skirt steaks, and top sirloin which costs $2 per pound at wholesale and retails between $5.99 and $6.99, reports Bloomberg Businessweek.

How Long Can Companies Hold The Line On Prices?

Only a few companies -- those with unique value to customers -- will be able to raise their prices to keep their margins. The rest will probably engage in a combination of accepting lower margins and trying to cut their other costs to keep their margins from slipping. Those cost cuts could mean throwing more people out of work which would slow down consumer demand and cut into sales growth.

But the real issue is whether these companies will ultimately be forced to raise their prices in order to boost their earnings enough to meet Wall Street's expectations. The only way those price increases will stick is if all competitors follow. And in most industries there is too much rivalry for that to happen.

Perhaps the most common response will be to offer a broader array of lower quality products that carry the same prices as the higher quality ones did before those commodity price spikes. This will create the illusion in the minds of consumers that they are not paying more.

Alternatively, companies could raise prices across the board and companies could cut staff to maintain their margins. This would create a world in which the smaller number of people with jobs would be paying higher prices while the growing number of unemployed would suffer a further economic squeeze.

Stocks Quake As China Tightens

Global growth hinges on meeting the needs of the world’s largest country – China. Its economy is forecast to grow 8.7% in 2011 but things there are getting bubbly. With China's official inflation statistics up 4.4%, according to the Wall Street Journal, investors expect Its government to tighten by raising its interest rates on fears that inflation is out of control and a bursting real estate and stock bubble will create economic carnage.

What should investors do? The answer depends on whether you think the trend of the last several years is now shifting into reverse.

Moreover, China wants to raise the barriers to foreign capital which has been riding its real estate wave. China -- which in today's G20 meeting got agreement on the dangers of foreign capital flows -- has already cut its money supply by requiring banks to park more cash with the central bank; has raised interest rates once; and tightened controls on capital inflows into China.

China is certainly taking steps to stop the flow of what it considers hot money into China. Bloomberg reported that its State Administration of Foreign Exchange would tighten management of banks’ foreign-debt quotas; introduce new rules on their currency provisioning; and that the government will regulate "Chinese special-purpose vehicles overseas and tighten controls on equity investments by foreign companies in China."

China is also putting some brakes on its real estate market. It suspended mortgages for third-home purchases and pledged to speed up trials of property taxes nationwide. It also raised interest rates in October for the first time in three years on concerns of inflation and "relentless growth in asset prices," according to Bloomberg.

How China's Tightening Slams Stocks, Commodities

All this tightening has repercussions for investors. Gold is tumbling as investors wager that China’s demand will decline – and other commodities prices should follow. Stocks are also falling -- Chinese stocks plunged 5.7% -- as fears of slower growth in the wake of China’s declining appetite cascade through markets around the world.

Chinese stocks are tumbling limit down in commodity, airline and automobile sectors. As the Journal reported, these plunges included: China Southern Airlines (-10% maximum), Hong Yuan Securities (-10%), Jiangxi Copper (-8.9%), SAIC Motor Corp. (-8.6%), Yunnan Aluminium Co. (- 9.4%), Chinese property developers China Vanke Co.(-7.1%) and Poly Real Estate Group (-7.3%).

Does this mean that investors are not afraid of out-of-control inflation just around the corner? After all, they've been braying about apocalypse now due to Fed-fiat-money-printing for years. But that did not stop them from taking profits on gold, oil, and silver. Spot gold fell by over 2% to $1,380.20 per troy ounce, Nymex December crude-oil futures declined $2.08 at $85.73 per barrel; and Silver lost 2.5% of its value.

How Investors Should Respond

Does this represent a permanent shift in the investment climate or just an excuse to take profits before the bet on rising commodity prices resumes? If China's tightening was really a fundamental shift in policy that will lead to lower growth there, then it seems likely that today's moves would have been anticipated by investors.

But if these moves really are a surprise, then many of the bets that investors have been making over the last few years are likely to be poised to plunge. Those are bets on a dropping dollar and rising commodity prices based on demand from China. If those trades are reversing, then investors ought to be placing bets on a stronger dollar and weaker commodity prices.

That would be great for American consumers. But my hunch is that today's action is just an excuse to take profits and those who have missed out on the rally in commodity prices and Asian equities might use it as an entry point.

Rethinking Japanese Management

Japanese management needs a Japanese-management-style rework. Simply put, some of its strengths have become a dangerous weakness. But other strengths could form the basis of Japan's future emergence.

How so? What brought America’s attention to Japanese style management was Japan’s evolution into a powerful economic rival to the U.S. in the 1980s. What management scholars found when they studied Japan was a set of powerful management principles:

• A spirit of continuous improvement;
• A so-called Convoy system in which large, manufacturing-based enterprises created closed networks of suppliers and distributors;
• Close attention to details of product quality supported by cross-functional communication;
• Linking a detailed understanding of customer needs with a work environment that motivates workers to satisfy those needs;
• A willingness to learn from competitors’ best practices;
• A system of lifetime employment that passes down wisdom from more experienced employees; and
• Government-directed industrial policies which create controlled Darwinism by spurring the emergence of fierce competitors in targeted industries.

But the flip side of these positive aspects of Japan’s management skill is a set of historical weaknesses, according to the Japanese Association of Corporate Executives, including:

• A lack of an international perspective leading to weakness in diplomacy;
• A tendency to base decisions on emotional factors;
• A conformist mentality: “hammering down the nail that sticks out;”
• Insufficient self-reliance and independence; and
• An ostrich mentality -- when faced with challenges, an instinct to simply hope that things will turn out alright in the end.

Since Japan’s bubble burst in 1989, its economy has spent two stagnant decades during which the world has lost its fear of Japan. Since then, Japan has gone from the second largest economy to the third. And one of its largest companies, Toyota, continues to be mired in quality problems that threaten a core aspect of its franchise – the idea that it makes the best quality vehicles for which it can charge a price premium.

Nevertheless, many Japanese management principles still make sense. Of these, the spirit of continuous improvement coupled with a desire to keep learning can form the basis of Japan’s economic revival.

To revive economic growth, Japan needs to lose some of its traditional management principles. For example, the convoy and lifetime employment systems lock Japanese companies into inflexible relationships that make it difficult for them to respond to new technologies and to emerging competitors. Japan must also become more international and learn to confront problems instead of hoping they’ll go away.

Nevertheless, there are fundamental tenets of Japanese management which remain relevant around the world. Of these, the four most important ones are as follows: 

• Linking a detailed understanding of customer needs with a work environment that motivates workers to satisfy those needs. This remains a useful principle, but leading companies are taking it a step further. Instead of merely listening to customer needs, these leading companies are getting ahead of customer needs by thinking about the future trends that will change the lives of their customers’ customers. By thinking about such trends, leading companies come up with new products that anticipate the trends and position their customers for market share gains. The leading companies can, in turn, build an organization that supports those products.
• Close attention to details of product quality supported by cross-functional communication. This principle continues to be important – particularly for products and services where customers value extremely high quality. In this, Japan remains unparalleled. Unfortunately, Toyota lost its way when it came to quality because it decided to put rapid growth ahead of the need to transfer the quality mentoring process across management generations. But those quality principles still make eminent good sense.
• A willingness to learn from competitors’ best practices. This scholarly approach to competitors can be very useful – but also risks being a trap. If this analysis is used to identify opportunities to outperform competitors in satisfying customer needs, then it will help companies to gain market share. If the competitor analysis is used merely to keep pace with these competitors, it could be a waste of time.
• A spirit of continuous improvement. Continuous improvement could be the core of Japan’s economic emergence if that spirit is applied properly. And it is a principle that companies around the world ignore at their peril. Specifically, Japan needs to turn that spirit of continuous improvement inward to examine the root causes of its two decades of economic stagnation. Moreover, it needs to do something uncharacteristic – which is to confront these causes boldly with creative solutions. From there, it can develop strategies that boost growth. The rest of the business world could do far worse than to emulate this key principle of Japanese management.

These days, the U.S. seems keen on avoiding the many economic policy mistakes that have mired Japan in two decades of deflation. But the world business community owes it a debt of gratitude to Japan for its management innovations -- and these four principles continue as a beacon to managers everywhere.

Are Democrats Better For Stocks?

Back in 2004 I was a source for a Forbes article on presidents and the stock market. The Forbes article reviewed research by UCLA professors that concluded that Democratic presidents were better for stocks.
 
Going back to 1927, they found that the S&P 500 averaged 14.1% per year under Democratic presidents and 11.8% under Republican presidents. Here was Forbes’ 2004 list of presidents and the S&P 500 performance average annual performance while they were in office:

• Bill Clinton (+17.4%)
• Gerald Ford (+17.0%)
• Harry Truman (+15.6%)
• Dwight Eisenhower (+14.9%)
• Ronald Reagan (+14.4%)
• George H. W. Bush (+14.4%)
• John Kennedy (+12.4%)
• Jimmy Carter (+11.2%) 
• Lyndon Johnson (+10.2%)
• Richard Nixon (0.6%)

Since then we’ve had two more presidents (one still in office). Here’s the average annual performance of the S&P 500 under their presidencies:

• George W. Bush (-4.5%)
• Barack Obama (+26.9%)

Simply put, W’s stock market was the worst since 1945 while Obama’s has been the best. That’s something to think about as you go to the polls today.