Inflation is bad for
consumers, but not
necessarily for investors

NEW YORK » The latest inflation scare to grip Wall Street isn't by itself a good reason for equity investors to take cover, analysts say. Instead, they recommend looking for companies that have pricing power -- the ability to pass on their higher costs to customers.

Costs for raw materials have been rising for a while, but signs that higher prices are starting to trickle down to consumers caused further alarm this week. The Dow Jones industrials slumped 95 points on Tuesday after Federal Reserve policymakers cited a pickup in inflation pressure as they again boosted short-term interest rates. A day later, the government reported the Consumer Price Index rose 0.4 percent in February as costs for everything from food and lodging to health care and education inched higher.

But inflation is still far from worrisome levels, said Tobias Levkovich, chief U.S. equity strategist at Citigroup's Smith Barney division. In fact, it wasn't so long ago that Wall Street was worried about deflation, he noted.

"We all have to kind of step back and take a deep breath, and not run to erroneous conclusions," Levkovich said. "The Fed was trying to say 'We're going to be vigilant.' They were trying to send a message to the bond market that 'We're not going to allow inflation to get out of hand.'"

Furthermore, Levkovich and other analysts said the perception that inflation is directly linked to soaring oil prices is off base: Energy accounts for less than 3 percent of corporate costs -- a fraction of the 70 percent linked to labor. And as long as jobs and production can be outsourced, wage inflation is unlikely to become an issue.

"Usually you don't start to see inflation run away until it starts to get embedded into wages," said Jeff Kleintop, chief investment strategist for PNC Financial Services Group in Philadelphia. "In the meantime we'll see pockets of pricing power throughout the economy."

One of the easiest ways to get a sense of which industries have the ability to make price increases stick is to review the government's monthly CPI report, available on the Bureau of Labor Statistics Web site. The 5.6 percent year-over-year increase in dairy products, for example, is a trend grocery shoppers know all too well.

"Food away from home" is one category on Kleintop's radar. This group, essentially comprised of restaurants, rose 3.2 percent in the last 12 months. That kind of pricing power is one of the factors his firm considered before investing in food franchiser Yum Brands Inc., the parent of the KFC, Pizza Hut and Taco Bell chains.

Education prices rose 6.3 percent overall, year-over-year, and prices for books and other supplies increased 3.2 percent -- one of PNC's considerations in owning textbook publisher McGraw-Hill Cos.

The 7.4 percent year-over-year price hike in the lodging category also has been hard for professional investors to ignore. PNC owns stakes in Starwood Hotels & Resorts Worldwide Inc. and Marriott International Inc.

"The CPI is interesting," Kleintop said. "You can kind of see the trends, in some cases, before the stocks begin to move and before analysts are seeing things moving ... so it pays to pay attention to something like that."

Supply constraints are helping create pricing power in the lodging industry, according to Smith Barney's Levkovich. It takes years to acquire permits and to build new hotels, which limits the number of rooms available. An investment in Marriott would play right into that, he said.

Pricing power also comes into play in the energy industry. While rising demand from the United States and China is driving oil prices, the real issue is that the industry can't increase supplies fast enough. That favors oil field services companies like Cooper Cameron Corp., Levkovich said.

With the market locked in rangebound trading, and all eyes on the Fed and its moves on interest rates, it may be difficult for investors to spot such opportunities. And don't expect the noise to die down anytime soon, especially as economists look for signs of wage inflation.