Smaller companies tend to be more susceptible to inflation risk than their larger peers. However, while the broad asset class may be floundering amid the highest inflation in decades, in our view, compelling opportunities remain among certain high-quality international small caps.
How does inflation impact investing?
The burning question for investors right now is: How will inflation affect the value of an investment? There are several considerations here, including:
- Revenue growth – companies with pricing power are most likely to handle inflation best from a revenue perspective
- Operating margins – companies with low gross margins and significant input costs will see margins decrease as commodity costs rise
- Investment efficiency – uncertainty about the future of inflation will make it more difficult to determine potential long-term investment efficiency
- The cost of debt and equity – the cost of capital (both debt and equity) will increase, albeit to different degrees, in an inflationary environment and companies with strong balance sheets are likely to fare better in this scenario
- Failure risk – this risk is higher among younger companies with less-developed business models than at more mature businesses
In general, smaller companies have higher inflation risk because they may have a harder time absorbing higher expenses than their larger peers. It can be difficult for smaller companies to pass higher costs onto customers via higher prices, too. Plus, smaller companies tend to be more labor intensive than their large ones, so when labor costs increase during periods of inflation, small-cap company profits could be more at risk. But we think it would be unwise to throw the small-cap baby out with the inflation bath water.
What to look for among international small caps
Companies with certain characteristics, such as higher margins, lower margin volatility, strong balance sheets and higher returns on assets, which reflect relatively more established businesses or, as we call them, “leaders in niches.” We believe that there are international small-cap companies that possess these characteristics.
Companies that could be thought of as ‘efficiency enablers’, meaning those that provide critical services or products at a low cost, could represent compelling opportunities, in our view.
Companies that provide not-easy-to-replicate products and services that are difficult to dislodge from a competitive standpoint are more likely to succeed during periods of inflation. Think of companies that are increasingly interwoven and hard to extract from a customer’s way of doing business.
International small-cap companies like these, with important positions in the value chain, have power over customers and suppliers. This enables them to deliver higher and more stable margins than many other types of businesses. We think that among these companies, it’s important to identify those that have the potential to grow, along with considering product/market fit and profit scalability.
It’s important to note that these companies can, of course, experience sensitivity to the economic cycle, but during these times of sensitivity, we believe that there can be opportunities for them to ingratiate themselves even more within their customer base as they search for areas to become more efficient.
These types of companies can span several sectors, such as consumer discretionary, energy, consumer staples and more. Think of companies that create critical components to pharmaceuticals, niche energy companies that produce safety equipment for natural gas shipping or luxury perfume manufacturers. All of these represent the types of smaller companies that could fit the criteria we’ve identified for potential small-cap success amid inflation.
Certainly, these types of smaller companies exist domestically, too, so why consider international small caps? We think that there are potential “hidden gems” in this space. Beyond this, US investors typically have home bias, which could be blinding them to opportunities abroad.
Our outlook about small caps
So far this year, the key problem for investors has been unexpected inflation. Inflation expectations are a key component of understanding the future of inflation.
Consider the 1970s, an era marked by sky-high inflation, which many are comparing to today. At the time, the Fed thought it could keep interest-rate policy loose and unemployment low without putting much upward pressure on inflation.
But the Fed learned the hard way that this relationship can deteriorate and, in fact, decouple. Inflation rose to the point that inflation expectations became unanchored. An energy shock thanks to an embargo from international energy-exporting nations complicated matters further.
The result was high inflation and reduced public faith in the Fed’s ability to bring it down. In the end, the Fed had to do a lot of tough policy work (namely, raising interest rates) to bring it down.
We expect the pace of inflation to ease a bit in the near-term, which should help the economy regain some momentum, but, nonetheless, we expect the US to tip into recession before the end of 2023.
Against this difficult short-term backdrop, we think it’s prudent to focus on the long term, which continues to be attractive for predictable, well-financed businesses with products customer love to use in good times and bad. These types of companies are more likely to benefit from longer-term structural growth drivers. We also think that maintaining a nimble approach is important in volatile times like these, as short termism can create market dislocations and great long term opportunities.
All of this said, we believe that there are compelling opportunities among international smaller companies that find themselves in more attractive positions from a valuation standpoint now than they have in quite some time, with lower multiples providing a potentially more attractive entry point for long term investors.