Concerns over persistent inflation are forcing investors to look closely at asset class options to manage their portfolios and identify new opportunities.
Among them is the potential for small-cap equities, according to Francis Gannon, co-chief investment officer and managing director of Royce Investment Partners.
“If investors are looking for a way to play inflation, look no further than small caps. Using history as our guide, small caps are the only major asset class to beat inflation in every decade since the 1930s.”
Speaking as part of Franklin Templeton’s latest mega trends accelerate webcast, he said that following highly volatile markets, subsequent three-year small-cap returns have been strong on both an absolute and a relative basis.
“We are holding companies that are well positioned to sidestep the worst of today’s challenges, like those with pricing power, cash generative businesses with low debt, asset-light models and B2B businesses.”
Bullish in bear markets
Gannon points to the bear market territory as a reference point for how investors should consider the role of small-cap equities in their portfolios.
For example, while the S&P 500 Index has just entered a bear market, the Russell 2000 Index – a proxy for small caps – has been in a bear market since January.
“It’s important for investors to remember that bear markets happen, and more importantly, that bear markets end. Bear markets also provide opportunities for patient investors – tomorrow’s returns are on sale today,” he explained.
More specifically, although the average stock in the Russell 2000 Index is down between 45% and 50% from its 52-week high, with a lot of bad news priced into today’s market, the earnings picture for small caps is still healthy from a bottom-up perspective.
“Small caps are trading at 20-year lows compared with large caps,” said Gannon. “Even with outperformance on the small-cap value side versus small-cap growth, small caps are selling at a 54% discount.”
For investors eyeing small caps outside of the US, meanwhile, he said the focus should be on quality.
“[Investors should] consider companies that have high returns on investment capital and histories of longstanding consumer relationships,” added Gannon.
Appealing asset types
Investors should also be looking at the potential for commodities and real assets to weather the inflation storm.
“Commodities and real assets, such as private real estate and infrastructure, are reasonably effective hedges against today’s high inflation environment,” said Gene Podkaminer, head of research for Franklin Templeton Investment Solutions.
“Commodities are almost shorthand for what happens in inflation, and investors can look to more commodity-rich countries for exposure like Canada, Australia and Brazil.”
Given that inflation protection is part of a well-balanced and diversified portfolio, he added that Treasury inflation-protected securities and other global inflation-linked bonds do well in inflationary environments.