How to cut small cap risk when inflation is on the rise
Given the increasing threat of inflation, many investors are asking me what impact it will have on small companies. The quandary is that small caps are more volatile than large caps, but they can provide greater potential for long-term growth. For me, the answer lies in high quality stock selection.
After our recent webinar for investors in the Montgomery Small Companies Fund, we asked attendees to nominate subjects they’d like addressed here at the blog. One of the many considered responses was this question:
Q) Will inflation affect small companies (borrowings, service of debt etc) more than larger caps, then interest rises, wage inflation follows …so on. Have you a wary eye on this change in economic climate and how will the portfolio be positioned during a high inflation period. Thank you.
It’s helpful to answer this question because the vast majority of equity market investors stick to the large companies. The four major banks, BHP and Rio Tinto, Wesfarmers, Woolworths and the like feature prominently in the portfolios of most investors.
Often investors have no, or only a small exposure to small companies, believing them to be much riskier than larger companies. And there is some truth to that perception, but when it comes to investing, we are rewarded for taking risk. Uncertainty, and therefore risk, are also inherent in large companies. Most investors in large companies should therefore be familiar and comfortable with risk.
Warren Buffett’s 2IC at Berkshire Hathaway, Charlie Munger, famously reflected on the Global Financial Crisis in an interview for the BBC:
“This is the third time that Warren and I have seen our holdings in Berkshire Hathaway go down, top tick to bottom tick, by 50 per cent…In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50 per cent two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.”
Clearly, we need to do everything possible to mitigate the risk of substantial falls but if they prove to be temporary, rather than permanent, we should welcome them for the opportunity they deliver.
Are small companies any riskier?
There are several sources of risk associated with smaller companies.
The first of course is related to potential reward. Small companies have longer runways for potential growth and therefore can offer substantially higher returns. Consequently, there’s a correspondingly higher idiosyncratic risk. Idiosyncratic risk refers to inherent risks exclusive to a company, while systematic risk refers to broader trends that could impact the overall market or sector.
Idiosyncratic risks, include execution risk, strategy risk, competition, balance sheet or financial risk, regulatory risk, key man risk and this list is not exhaustive. Importantly, idiosyncratic risk can be mitigated – never fully of course – by a savvy fund manager applying their experience and understanding of the behaviour of other investors, knowledge of management’s ability, and through an assessment of the probability of success of the combination of the people, products, position and prospects of a company.
Successful small cap investing – we measure success by magnitude of, and consistency, beating the respective benchmark – does require extra effort simply because small companies tend to be more dynamic than mature companies whose competitive position and regulatory environment, for example, are more stable.
Another risk stems from the law of large numbers. Quite simply, there’s not enough room for every small company to become a large company. Some make it, some are taken over on the road to becoming large, and others disappoint. A large proportion will disappoint.
Again, this risk can be mitigated by a good fund manager.
Another risk relates to the listed market for small companies. Because small companies attract a lesser allocation of investors’ collective portfolios and by virtue of their smaller market capitalisation, they tend to be less liquid than larger companies. Establishing a position, and especially exiting a position when something goes awry, is often made more challenging by the absence of a highly liquid market for the shares of small companies.
Once again, the fund manager you choose to invest in small caps on your behalf matters. The relationships a fund manager has built with other investors including brokers, research analysts and a company’s management will go some way to mitigating the risks
Additionally, the lack of liquidity limits the volume of trading and consequently less research is justifiable by broking analysts whose research needs to drive revenue for their employers.
This lack of research means small cap investors are required to perform much deeper due diligence. Of course, the lack of research and many smaller companies also affords much greater opportunity.
Given the above, it follows that an appropriate weighting to small companies be considered. As always, the length of your investment runway goes some way to determining the weighting. For a given risk tolerance, someone in their 20s should arguably invest more in small companies than someone deep into retirement.
And what allocation to small caps is appropriate for those nearing retirement or just beginning their retirement today?
At 65 years of age an investor must consider funding 30 years of future spending. Over 30 years, one can expect the price of a nice bottle of wine to rise materially. I remember buying a bottle of St Henri Claret in the mid 90s for $15. Twenty-five years on, the same wine is $110 per bottle. In 30 years from now, St Henri might retail for over $1,000 per bottle.
Maintaining one’s purchasing power is the primary reason for investing in growth, and small companies offer the potential for fast growth and long runways on which to maintain or improve purchasing power.
Keeping inflation in mind, those entering retirement today cannot ignore the growth potential of small companies. At every stage of the investment journey, an allocation to small companies is required.
The subject of inflation inspired the original question, so it is appropriate to consider inflation’s impact on small companies. As expectations for inflation rise, government bond rates rise in anticipation of central banks increasing short-term rates. And those higher bond rates have a detrimental impact on the present value of future cash flows and therefore the intrinsic value of shares in a company.
Every asset is negatively correlated to interest rates. Interest rates act like gravity on the value of an asset. When rates are high, the gravitational force is strong and asset prices fall. When rates are low, the gravitational force is weak and asset prices float up. This is due to something called Present Value.
Suppose you were offered the choice of ten dollars today or ten dollars in ten years’ time. Which would you choose? You would choose today because there are so many risks and unknowns between now and the end of a decade. You also know intuitively that ten dollars in ten years’ time is not worth as much as ten dollars today. Inflation will make sure that you won’t be able to buy as much in a decade as it can buy today. Therefore, a bird in the hand is worth more than a bird in the bush (with apologies to John Capgrave). In other words, ten dollars in ten years’ time is worth something less than that today.
Assume if we invested today, we’d receive ten dollars in ten years. How much we need to invest today, to receive ten dollars in a decade, depends of course on the interest rate we earn. If the interest rate is low, we would need to invest a high amount today. If the interest rate is high, we would only need to invest a smaller amount.
The value today, of ten dollars in the future, changes depending on the interest rate. If the interest rate was 0.5 per cent for the next ten years, the Present Value of that future ten dollars is $9.51. In other words, if we invested $9.51 today at 0.5 per cent per year, we’d have ten dollars in ten years.
If however interest rates are expected to average 11 per cent over the next ten years, the Present Value of a future ten dollars is $3.52. If we invested $3.52 today at 11 per cent per year, we’d have ten dollars in ten years.
As you can see, gravity has had a huge impact on today’s value of a future dollar. In the above example, when interest rates jumped from 0.5 per cent to 11 per cent, the Present Value fell from $9.51 to $3.52!
In an inflation environment – where interest rates are rising – some small capitalised companies can be more sensitive. The most sensitive are those companies with no earnings today, those companies hoping to earn profits in the distant future.
The further out that hoped-for profit is on the horizon, the more sensitive the stock will be to changes in interest rates. Once again, this is where the quality of the manager comes into play. By investing predominantly in quality small companies, or by having an investment strategy that allocates appropriately between structural growth (growth not dependent on economic conditions), tactical opportunities and more established companies, a fund manager can reduce (but not eliminate) the volatility of returns typically attributed to smaller companies.
Thanks for the question and I hope the answer goes some way to explaining why every investor might find small company investing relevant and appropriate.