Small caps: Not all are the same

1. Liquidity refers to the ability of a company to pay off short-term financial obligations without raising additional external financing. The Quick Ratio is commonly used to assess liquidity and measures a company’s assets that can be converted quickly into cash relative to its short-term obligations. A company with a quick ratio higher than 1 owns more quick assets than immediate liabilities and can pay off these liabilities without selling long-term assets. A quick ratio less than 1 means that a company may struggle with paying debts. Stocks in theTravel & Leisure sector have a quick ratio of 0,6 – an indicator of high liquidity risk and poor financial health.
2. Solvency is defined as the ability of a company to meet both its short- and long-term financial obligations. The debt-to-equity ratio is a commonly used measure of a company’s solvency and measures its ability to repay its obligations. A debt-to-equity ratio greater than 1 means that a company is risky. Unlike equity financing, debt must be repaid to the lender and may prove far more expensive to roll over, particularly in an environment of rising interest rates. Companies that have little debt vs. equity are better insulated from failure. Most companies have capitalised on the low-interest-rate environment and current high market valuations to raise equity capital and shore up their balance sheets. However, Travel & Leisure's debt-to-equity ratio is 4,9 – once again an indicator of extremely poor financial health.
3. Viability assesses whether a company or sector will be profitable within a three-year horizon when the recovery from the COVID-19 crisis is expected to take hold. As we come out of the 2020 recession, weaknesses in the hotel and retail segments are more pronounced, reflecting the impact of mandatory restrictions and voluntary social distancing on the restaurants and travel and tourism industries. The prospects for the sector are unlikely to improve as tourism is expected to remain subdued until the pandemic is brought under control everywhere. Data from STATSSA shows that international visitors were responsible for 45% of all tourism-related spending before the pandemic. Pandemic-related restrictions on international travel and a more general fear of traveling are expected to have lasting effects on economic activity within the sector, indicating ailing viability for the industry.

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.