David vs The Inflation Goliath

Investing Daily Article of the Week

by Richard Stavros

Whether on the field of battle, facing a corporate competitor, or in a plan to combat inflation, time-and-time again, victory in all these endeavors has not come from the size of the army, company or portfolio. The deciding factor has been strategy.

The famous Chinese military general, strategist and philosopher Sun Tzu once said, “Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.”

In an overall inflation fighting strategy, many investors fail to incorporate small-cap stocks as part of the many tactics to preserve wealth. That’s probably because investing in small caps or even mid caps is not always easy. There are thousands of small-cap stocks and even isolating only the bottom 20 percent of small-cap names with the lowest price-to-book ratio results in several hundred stocks, which can be daunting for investors.

However, the Inflation Survival Letter uses tools and methodologies to identify and select the top small caps when discussing inflation protection. The better the investment, the better the inflation protection.

Failing to develop a small- and mid-cap portfolio can leave a major chink in the armor against inflation. Small- and mid-cap stocks comprise about 20 percent to 25 percent of total stock market capitalization, so a market-neutral exposure requires that a similar percentage of personal equity portfolios be allocated to small- and mid-cap stocks.

Because of recent evidence that large-cap stocks can be highly correlated with each other, some financial planners recommend that well-diversified equity portfolios have an overweight allocation to small caps (e.g. between 25 percent and 35 percent) that exhibit less inter-stock correlation than large caps and thus offer superior diversification benefits.

An investor who wants outsized returns must be invested in small-cap stocks. All ten of the top-performing stocks of the past decade were small caps and most were value stocks. Moreover, value investments outperform growth during inflationary periods (see “Sum of all Fears,” Survival of the Fittest, August 30).

But for the purpose of inflation protection, small- and mid-cap investing is a highly valuable tactic, because this asset class has performed best during inflation, which could be just around the corner.

The likely continuation into 2014 of Federal Reserve stimulus, as a result of the impact on the economy from the government shutdown, raises the specter of inflation down the road, which could affect both income and growth investments. In fact, some analysts predict inflation could start as soon as 2015, which means investors only have about one year to rebalance or insulate their portfolios from inflation.

Perception Versus Reality

The conventional wisdom suggests that rising interest rates are detrimental to the performance of stocks in general and to small-cap stocks in particular, both in absolute terms and relative to large caps, according to a report by Pyramis Global Advisers, which is a Fidelity Investment Company.

Many theoretical reasons underlie this perception. For example, small caps generally need more external capital to grow than large caps. Rising rates drive up the cost of capital, making growth more expensive. Higher interest rates might impose actual cash costs on small-cap companies, which would erode profit margins and/or lower future earnings growth.

Another reason for perceived small-cap underperformance, according to the Pyramis analysts, is that the market ultimately values equities based on discounted future cash flows. In most circumstances, higher interest rates mean higher discount rates. Small-cap valuations would seem to be more sensitive to higher discount rates because they tend to be “longer-duration” assets whose valuations are more dependent on future earnings streams.

According to the Pyramis report:

“During the past several decades, however, rising interest rates have actually not been correlated with small-cap underperformance. Examination of the performance of the Russell 2000 Index and the S&P 500 since 1979 (the inception date of the Russell 2000) reveals what for many investors may be surprising results. First, small-cap stocks performed better than large caps when rates rose. Second, small caps actually have shown better absolute appreciation in rising rate periods than in declining rate periods. This data seems to refute the idea that periods of rising rates punish small-cap performance, and are by themselves a strong enough factor to influence small-cap stock allocation.” (See Chart A)

Chart A: Small Caps Outperformed in Rising Rate Environments

Jim Fink, chief investment strategist of Investing Daily’s small-cap advisory, Roadrunner Stocks, has written that small companies excel during inflationary times because they typically offer unique products with few alternatives, so they have more leeway to raise prices than larger firms.

What’s more, they can adjust pricing and behavior on the fly. A big company run by centralized management on a five-year plan isn’t as nimble. “Like zippy little PT boats, small stocks can quickly change course,” he has stated. He adds, large-cap “battleships” may have more firepower, but they take forever to change direction.

Thriving in Inflationary Environments

According to Doug Roberts, chief investment strategist at Channel Capital Research.com, inflation is actually positive for small-cap stocks in the long run. During the 1977-79 peak of the inflationary 1970s, for example, blue-chip stocks went nowhere, but small stocks surged. As Roberts recently asserted:

“People say ‘stagflation, it’s going to kill the equity markets.’ And to a certain extent, it has in the past, but that’s from a large-cap perspective. If you take a look at small caps, even on an inflation-adjusted basis, it’s like a rocket ship taking off. Small caps actually had the rally of their lifetime during the stagflation environment [of the late 1970s]. You had high double-digit returns during that entire stagflation period with the exception of one year.”

In fact, in six major inflationary periods since World War II, including the Korean War, the Vietnam War, the OPEC oil crisis and the Persian Gulf War, small caps beat large caps. When you add up the returns over all six periods, small caps were up 82.6 percent, versus just 35.1 percent for large caps. That’s a 47.5 percent margin of outperformance for small caps. During these same inflationary periods, mid-cap stocks ($3 billion to $10 billion) outperformed large caps by a smaller but still significant 29 percent.

Times Square Capital Management finds in a recent report that not only do small- and mid-cap stocks preserve value during inflationary periods, but the margin of outperformance over large-cap stocks is the highest even when inflation is average.

According to the Times Square report:

“Since not all inflationary periods are created equal, we also investigated performance across the market capitalization spectrum during periods of high and low inflation based on the long term average inflation rate-the ‘historical norm’, or average inflation of 3.14 percent. While small capitalization and mid capitalization equities maintain their outperformance edge over large capitalization stocks in both high and low inflation environments, the margin of relative outperformance is greatest during inflationary periods when lower than average inflation exists.” (See Chart B)

Chart B: High Inflation, Low Inflation: Small-Cap Stocks Deliver Value

The best way to get exposure to the small- and mid-cap sector is to identify those companies that have strong earnings. And given how volatile the sector can be, it’s probably best for inflation hedgers to pick a diversified index whose criteria focuses on the highest-quality names.