Inflation is back – what next for small caps?

Inflation is back – what next for small caps?

What does inflation mean for global stock markets and more specifically, the shares of smaller companies? We think there are two main considerations. The first is what inflation means for monetary policy around the world. As central banks shift their stance the dynamics of equity markets can be transformed. The second is the impact of higher inflation on individual companies.

Markets have rotated

We’ve seen highly-rated growth stocks selling off as with interest rates moving up, investors are now less willing to pay as much for the longer term cashflows anticipated from “jam tomorrow” growth stocks. This has generated a major rotation towards lower-rated stocks, at both the large and small-cap ends of the market. Sectors viewed as inflation winners, such as oil, mining and banking, have led the way in the last six months.

Where have we seen opportunities?

We have moved to selectively increase exposure to stocks in these sectors. We have added to Kirby Corporation, which is exposed to the oil services industry and Bristow Group, a helicopter operator with a focus on the offshore oil sector. We have also added to our holding in Lundin Mining, a Canada-based copper miner, benefitting from increased demand amid a global energy transition. Elsewhere, we have maintained a large position in the UK challenger bank OSB Group, which is enjoying enhanced net interest margins in its buy-to-let lending business, and have introduced a new holding, Paragon Banking Group, which is seeing a similar uplift to return on equity.

Cost pressures – what do they mean for individual companies?

Smaller company investing however, is mainly about individual company analysis, so we need to consider is the impact of higher inflation on each stock, specifically their operating performance and outlook. Some companies, for example US listed Brown and Brown, an insurance broker are net beneficiaries from rising prices as their income stream is directly linked to higher insurance premium rates, while costs have been growing less rapidly. Shipbroker Clarkson has been another direct beneficiary, as shipping rates and ship values have picked up too, while agricultural crop protection supplier American Vanguard, has been helped by stronger demand from farmers against the backdrop of surging grain prices. For many companies, however, inflation will represent a profit headwind. This is especially true at in the present time when cost pressures are so widespread.

What we need to consider is the impact of higher inflation on each stock, specifically their operating performance and outlook.

We expect to see that margins are being squeezed

When companies eventually report 2022 results, we are expecting to see evidence of margins being squeezed as it will take time, in many cases, before higher input costs can be recovered. To this end, we are already seeing some downgrades coming through in analyst projections. Some companies in our portfolio, such as Treatt, a specialist natural ingredients supplier to the food and beverages market, are better placed to pass on cost rises, as their share of their customers end-market sales price is low. Similarly, US listed Nomad Foods, a frozen foods supplier to the European markets should be able to protect its margins because of the strength of its brands in the market such as Birds Eye. Luxury brands are also probably better placed to pass through increases in costs as their customers are feeling less impacted by the cost-of-living squeeze. To date this has been the case with our holding Hotel Chocolat. Where underlying demand is weakening, such as in some industrial sectors like the automotive area, supply chain challenges are adding an extra complication to the battle for recovering higher costs, and our holdings in TI Fluid Systems and Trifast have been impacted by this.

Emphasising strong quality companies

With economies already showing signs of weakness, investors are faced with the negative potential scenario of stagflation; namely lacklustre growth combined with high inflation. The unpredictable situation in Ukraine could be pivotal in how the debate around this moves forward, and a lowering in inflation expectations could change the current mood once more, only time will tell.
While it is clearly a challenging time on the macro side, in the meantime we are seeing better value now in parts of the market, with several previously well-loved growth stocks having fallen well out of favour. This could present opportunities to access some long-term winners at attractive levels. More conceptual, unprofitable businesses not generating free cash-flow may remain under pressure for a while though, especially as the cost of capital has just gone up a few notches for all businesses.

Fundamentally, having a balanced portfolio and not getting too carried away in terms of valuation is likely to be the best approach to navigate these tricky times. Small cap businesses with strong franchises and strong balance sheets, will, we believe, come out on the other side in good shape.

Find out more about CT Global Smaller Companies

30 May 2022
Peter Ewins
Peter Ewins
Director, Global Small Cap
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Risk Disclaimer

Past performance is not a guide to future performance.

The value of an investment is dependent on the supply and demand for the shares of the Investment Trust rather than its underlying assets. The value of an investment will not be the same as the value of the Investment Trust’s underlying assets.

Investments in smaller companies carry a higher degree of risk as their shares may be less liquid and investment values can be volatile.

Views and opinions have been arrived at by Columbia Threadneedle Investments and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

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