As we continue to climb out from the effects of the global quarantine, the post-Covid-19 world for earnings and economic growth is becoming more apparent. The IMF has upgraded its 2021 global growth estimate to 6%, boosted by the $1.9 trillion fiscal stimulus in the United States. In general, the acceleration in fiscal spending across most major economies since the start of the pandemic has had the following impact:
In addition, at nearly $10 trillion globally, central bank asset purchases have played a crucial role in keeping interest rates low. Unfortunately, the aggressive fiscal and monetary policy actions have stoked investor fears that inflation is set for a return. The yield on the 10-year US Treasury note has increased, reflecting improved prospects for economic growth and inflation. High inflation is often regarded as an enemy to equity investors; however, small cap stocks have historically provided a reasonable hedge against inflation, particularly when both the economy and long-term interest rates rise.
Companies in the FTSE/JSE Small Cap Index have underperformed the market by -2% over the last ten years. This result is not surprising as the environment has been characterised by stagnant inflation and declining interest rates. Now that things are changing, is this the right time to invest in small caps? Not necessarily! Companies, small caps or otherwise, provide an appropriate inflation hedge only when they have pricing power. Warren Buffett once put it - “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you need a prayer session before raising the price by a tenth of a cent, you’ve got a terrible business.” Companies will provide an appropriate inflation hedge when they have real pricing power, consistently raising prices faster than inflation.
So, what does real pricing power look like in the real world? Pricing power can exist at a sector or company level. Sometimes it is a result of the specific dynamics of a particular industry. It is not always easy to spot, but it is easy to find sectors or companies with no real pricing power. The Travel & Leisure sector is an example of an industry that lacks real pricing power. City Lodge Hotel Group, Famous Brands Holdings, Tsogo Sun Holdings, and Sun International provide exposure to the sector. Together, they comprise only 0,2% of the FTSE/JSE All Share Index.
The IMF Global Financial Stability Review provides a risk-based framework that can assess a sector or company's pricing power by evaluating Liquidity, Solvency, and Viability measures.
Small caps have historically provided a good inflation hedge, particularly during early economic expansion phases when interest rates rise. However, the post-COVID-19 world will be characterised by an uneven recovery at a sector level. Not all small caps will be able to provide the inflation-hedge qualities. Pricing power is critical, and investors may be best served applying a selective approach to avoid stocks with ailing viability and poor financial health, such as those in the Travel & Leisure sector.
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