Inflation has roared back into the world over the past six months, with prices in the UK up 6.2% year-on-year in February.
As an investor, not losing money in real terms is extremely difficult in this environment. An asset will need to clear 6.2% per year just to keep pace with rising prices, but this can be even more with additional fees for investing factored in.
However, one area adept at beating inflation is smaller companies. Looking back to the 1930s, the US smaller companies index has beaten inflation in each of the past nine decades, including the 1970s, when inflation was at 8.1% for the decade.
Source: Franklin Templeton
Brendan Hartman, co-manager of the Legg Mason Royce US Small Cap Opportunity fund, said there is no direct correlation between inflation and smaller companies, but that the potential for these fledgling firms to grow at a fast rate has always been a positive.
“It has to come back to the earnings of the small-caps and the resiliency and sustainability. There are certain areas of the market such as consumer or retail that don’t have that, which is where the stock picking comes in, but inflation is everywhere today,” he said. “To me, small-cap is the most attractive asset class today.”
So confident in the approach, he has sold a number of large-cap tech names from his personal portfolio while lifting the allocation to his own fund.
The resiliency of smaller companies has only improved in recent times, he added, as they are now far more international and have pricing power, something they have not in the past.
“In general these companies have pricing power. We own 240 stocks today and the majority have pricing power and are playing catch up to the raw material inflation but can pass that through,” he said.
As such, Hartman said it would make sense for investors to switch out from an asset class such as bonds, where funds have been struggling, and into smaller companies.
“Relative to bonds, it makes sense that money would go into small-cap stocks when it is coming out of the bond market. It comes down to the phrase TINA – there is no alternative – to stocks,” he said.
“You might not love small-caps but you can’t put money in cash or bonds and so it has to be stocks. Within that, small-caps are a great way to invest.”
Hartman said the biggest risk to investors was not being in the market, whether through nervousness or from trying to time the peaks and troughs.
“You might miss a big drawdown such as during Covid or the financial crisis, but if you didn’t get back in at the exact right point you missed out on the biggest returns out there,” he said, pointing to Legg Mason Royce US Small Cap Opportunity’s impressive returns of 41.7% in 2009 following the financial crash.
Total return of fund in 2009
Source: FE Analytics
At present, the one of the main issues facing nervous investors is the fear of softening economic growth, which has yet to occur as the job market remains “healthy”. However, this could change as we near the anniversary of the US government providing Covid stimulus.
“We are concerned that we will see consumer spending weakness related to both the inflation and the anniversary of the free money,” he said.
If this is the case, it is likely a recession will be shallow, as there is less leverage in the system than during the financial crisis.
Yet it is not his base case. Indeed, the manager is investing for a rebound, with housebuilders among his favoured picks.
“We are constructive on the US housing market, both new home construction and repair and remodel constructing. We own four or five housebuilders and a handful of building supply companies that are a play on the consumer spending on their home,” he said.
Another area is aerospace and defence, where the fund is overweight (although they are listed as ‘industrials’ on the fund’s factsheet). Both have been hit by the pandemic, but have started to come back so far this year.
“Those stocks got crushed but we found some smaller companies that are critical to Boeing and Airbus both on new plane production and after-market spare parts,” he said.