With the global trading system beginning to fracture into two blocs – one around China, the economic challenger, and the other around the United States – smaller company stocks might well be the longer-term winners.
To a degree, this is the result of rising populism. Voters in many developed economies are in the middle of a cost-of-living crisis, which they blame in part on foreign low-cost manufacturers.
That’s why the US administration wants to bring manufacturing back home, increasing the likelihood of inflation returning to the higher levels of the 20th century.
For investors, it’s a confusing new world but one that over the longer term logically, and somewhat counter-intuitively, suits smaller company stocks. Today, many of them come from the ‘old economy’ sectors such as industrials, materials and energy that tend to do well in such inflationary times.
What’s more, they are currently trading at much lower valuations than larger companies, not discounting high-growth years into the future. By contrast, the current large-cap stocks are in the ‘growth’ sectors like technology and communication services, which tend to do less well when inflation and interest rates are relatively high.
The shorter term is likely to be uncertain and volatile, an economic slowdown is a distinct possibility. However, once the dust settles, the relative investment merits of smaller companies should start to become clear.
The famous US author Mark Twain is reputed to have said that history doesn’t repeat itself but often rhymes. In similar cycles over the past 250 years, notably the 1930s, economic struggles have sparked populism and trade friction, accompanied by war and inflation.
During the 1930s, though, small-cap stocks performed extremely well. They also outperformed in the ‘stagflationary’ period of the 1970’s. Arguably, today is similar to the 1930s, even if the difficulties do not appear so severe.
The global financial crisis of 2008-2009 has been followed a decade or so later by the emergence of populism and a trade war. Meanwhile, a real war is raging in Ukraine and the Middle East, with tensions also high between China and Taiwan.
Logically suited to a new world
Why might smaller companies perform relatively well at such a time? In addition to their value, old economy characteristics, they trade largely within their own countries, relying less on international sales.
As government policies aim to stimulate national economies, for instance through rising defence spending, smaller companies are more likely beneficiaries than larger ones.
If there is high inflation, one advantage higher quality smaller companies have is that they are nimble and adjust quickly. Focusing on niche markets, they are often dominant players and pass higher costs on to customers.
This helps them to maintain profitability better than more bureaucratic, slower moving larger companies that may have complicated global supply chains.
Thinking of the types of companies that do well in a higher inflation world, it’s useful to examine the different compositions of the large- and small-cap stock market universes.
More than a third (37%) of the MSCI ACWI Large Cap Index is in technology and communication services stocks, with only 15% in industrials, materials and energy.
But the MSCI ACWI Small Cap Index is its mirror image: it has just 16% in technology and communications services and a whopping 31% in industrials, materials and energy.
In other words, small-cap stocks are well positioned for a higher inflation world. And large-cap stocks appear to be in some of the more vulnerable sectors.
Actively steering the fund
Such volatile times are suited to professional investment managers, who actively steer portfolios towards the stocks likely to perform well. If the world is characterised by geopolitical tension, higher inflation, elevated interest rates and labour claiming a greater share of the economy, then it seems logical to own superior companies with pricing power and robust finances.
They should be local businesses that don’t have much of their cost base in the form of labour. You also want to be sensitive to valuations, given the prospect of higher interest rates than we have been used to.
For that reason, The Global Smaller Companies Trust only has 10% of its assets in technology and communications services stocks – even less than the 16% in MSCI’s ACWI Small Cap Index. It’s very overweight in industrials and materials, with 38% of the fund dedicated to those sectors, compared with 27% for the index.
Those choices are also reflected in its regional allocations. Just 45% of the trust is invested in North American companies, less than the MSCI index’s 60%, as a lot of them are technology and so-called ‘long duration’ stocks. The trust is tilted towards the more value and out-of-favour markets like the UK (20%) and Europe (10%).
To give examples of individual companies, the trust owns diversified industrial companies including Bodycote and MSC Industrial Direct. In defence, we own Chemring and Curtiss Wright. And in construction materials, we own Breedon Group and Martin Marietta Materials.
In such confusing times, logic tells us that higher quality smaller companies such as these are likely to have relatively robust prospects. One can never be certain, but smaller companies appear to be on the right side of history.
Nish Patel is manager of The Global Smaller Companies Trust. The views expressed above should not be taken as investment advice.