What higher inflation means for the world’s smallest companies

Inflation is back. We can all see it in our daily lives. But what does this mean for global stock markets and, more specifically, the shares of smaller companies that have tended to outperform over the long term?

Peter Ewins, manager of BMO Global Smaller Companies answers this question and more, in this round-up.

“There are two main aspects to consider with inflation,” said Peter. “Firstly, the consequences for global central banks’ monetary policy.

“As we have already seen, interest rate moves have the power to transform the dynamics of the equity markets.

“Shares are generally valued based on cash flow projections into the future. With interest rates moving up on the back of elevated inflation, investors are now less willing to pay as much for the longer term cash flows anticipated from “jam tomorrow” growth stocks and they have sold-off.

“This has generated a major rotation out of growth and into 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.”

Repositioning portfolios

“The BMO Global Smaller Companies trust has increased its exposure to stocks in these sectors,” continued Peter.

“In North America, for example, we have added to our holdings in Kirby, 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, benefiting 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.”

Individual impacts

“Smaller company investing however, is mainly about individual company analysis, so the second vital aspect to consider is the impact of higher inflation on each stock, specifically their operating performance and outlook,” said Peter.

“Some companies – for example our US listed holding Brown and Brown, an insurance broker – are net beneficiaries from rising prices. The company’s 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 in the present time when cost pressures are so widespread.”

A margin squeeze in 2022 results

“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,” said Peter. “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.”

A tricky period ahead

“With economies already showing signs of weakness, investors are faced with the negative potential scenario of stagflation; namely lacklustre growth combined with high inflation,” continued Peter. “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.” Concluded Peter.

“Small cap businesses with strong franchises and strong balance sheets, will, we believe, come out on the other side in good shape.”