Inflation may be a good thing for small caps

Jennifer Schonberger | Jun 20, 2008 3:37pm EDT | Comment

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When investors hear inflation, equity markets usually run for the exits, as inflation is generally bad for stocks.

Two economic indicators for inflation recently signaled an uptick in nominal terms, as oil has remained at heightened levels. For the month of May on a year-over-year basis, the consumer price index was up 4.2%, while the producer price index jumped 7.2%, marking the eighth consecutive month in which that number was above 6%, which hasn’t happened since 1977 to 1982.

But inflation may not be as negative for small-cap stocks as large-cap stocks.

“[Inflation] is actually pretty good for small caps,” Mary Lisanti, president and chief investment officer of AH Lisanti Capital Growth, said. “Even the 20% inflation we saw in the ’70s was good because their stuff is differentiated enough that they can raise prices.”

Lisanti also points to better control of costs for reasons why small caps wade inflation better than their larger brethren. “These things are working for them now that worked against them for the past four or five years,” she said.

In an interview in March, Lisanti said, “The best of all worlds for small growth stocks is one in which GDP is growing slowly, inflation is modest, and rates are low — such as the early 1990s.”

According to Doug Roberts, author of the book Follow the Fed to Investment Success and chief investment strategist for ChannelCapitalResearch.com, inflation is actually less negative for small-cap stocks in the short-run and positive in the long run.

Roberts uses what he calls the “battleship and PT boat analogy” to explain why the effect of inflation on small caps can be less negative than on large caps. “Even though a PT boat is smaller, if you're trying to shoot it, it has increased speed and can adjust pretty quickly, whereas a battleship, even though it's bigger and has more fire power is very, very difficult to turn,” Roberts said in an interview with SmallCapInvestor.com.

Parlaying this analogy to small caps, Roberts says smaller companies can adjust quickly to a change in inflation, in terms of its pricing and behavior, whereas a large company isn’t as nimble in adapting to the situation, as typically they have central planning and five-year plans.

Roberts points to historical periods for how small caps performed in an inflationary environment. When the Fed started raising rates in 1981 to choke off inflation, even though small stocks were down, they were down less than large stocks and they still continued to outperform for the next roughly two years.

During the late ’70s, Roberts says the Fed raised rates, but didn't raise rates so aggressively that negative real interest rates have still prevailed into really inflation. Therefore, he says, there was still net liquidity being added to the economy.

“That’s one of the reasons why you saw, as the Fed started lowering rates massively, you seen actually small caps start to outperform large caps this year,” Roberts said.

If inflation starts kicking into the system, Roberts says you'll see a back and forth. “Small caps may not necessarily be positive in some of these environments but they will outperform large caps,” Roberts said.

Year-to-date, the Russell 2000 and the S&P Small Cap 600 index are off 3.32% and 1.2%, respectively, while the S&P 500 — the standard benchmark — has been grinded down 8.5%.

“It’s tough to isolate inflation and say what the impact is going to be,” said Ian Corydon, director of research at B. Riley, to SmallCapInvestor.com. “You have to look at it in the context of what is going on in the economy.”

Not all small-cap stocks are impacted equally by increases in inflation. “Many small-cap investment managers are looking to position their portfolios in companies that can effectively manage input costs, maintain pricing power and preserve their margins during an inflationary period,” said Christian Anderson, associate Portfolio Manager for Russell Investments' U.S. small-cap funds, in an interview.

For consumer companies, Corydon says inflation is generally a negative because you can’t pass it on in this consumer environment. For commodities, on the other hand, such as oil and natural resource type companies, Corydon says inflation may be less of a factor or a neutral factor because those types of companies have a better ability to pass increases in costs on because they sell items you can’t do without.

“You’ve seen people piling into commodity companies as a hedge against inflation,” Corydon said. “You can’t do without oil, you can’t do without basic food items, but you can do without going to Outback Steakhouse or buying a new shirt.”

Corydon says investors can protect themselves by looking at the small-cap companies that have very good balance sheets who don’t need to raise capital and who don’t have debt.

“[Inflation] could affect individual small caps, but as a whole, the category is probably going to do pretty well, unless the Fed starts to raise aggressively,” Roberts said. “But I just don't think that's going to happen because they have a dual mandate.”

Roberts said he thinks that if the Fed starts raising rates it will be on a very gradual basis, so it will still be a favorable environment for small caps.

However, Roberts cautions if the Fed was to all of the sudden to begin tightening, and pulling some of the liquidity out of their system, that would be cause for concern. All in all he says, “I'm not that concerned about it.”

Although inflation is a concern for investors, domestic growth has grinded to a near halt and stagflation has also crept up as a possible concern.

“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,” Roberts said. “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. You had high double-digit returns during that entire stagflation period with the exception of one year.”

“It doesn’t matter to [small caps] at all, again for the same reasons that inflation didn’t bother them,” Lisanti said.