Eric Green, CFA, Chief Investment Officer – Equity, Senior Portfolio Manager, Senior Managing Partner of Penn Capital Management Company, LLC, one of our boutique managers, addresses some top-of-mind questions as we enter August.
1. Where do we go from here after a big run in small cap stocks?
We believe small cap stocks can continue to outperform over the next few years. Prior to last year, small cap stock returns trailed large cap returns for several years. Outperformance of small versus large and vice versa tends to occur in cycles lasting five to ten years. We believe that we are in the first year of small cap outperformance and it seems that fundamentals are aligning with this outlook. Small cap stocks tend to outperform when economic growth is improving, even outperforming when interest rates and inflation are increasing.
2. Inflation, secular or transitory?
A major question today that continues to be hotly debated is whether inflation is secular or transitory as the Federal Reserve has described today’s inflation.
We believe that inflation is more than transitory and we will see permanently higher prices. Our rationale is that labor costs are increasing and cannot reverse. Commodity price increases as well as supply chain issues can be transitory. However, once a business increases wages, they cannot cut them in the future. These wage increases will force businesses in various industries to raise prices to sustain margins. Sustained inflation is not necessarily a negative for the market. It allows pricing power and forces companies to improve efficiencies and productivity. As previously mentioned, inflation has generally been positive for small cap stocks in particular.
3. What does our credit lens tell us about future equity prices?
Strong credit markets have led to spreads reaching the lower end of their range over the last 15 years. Absolute yields recently hit all-time lows. Issuance has been strong, and more importantly, the vast majority of issuance has been refinancing at lower coupons pushing maturities out several years. The lower coupons allow for higher free cash flow from the issuer in future years. The projected default rate for 2022 is expected to be approximately 0.65%, which is well below the historic average of 4.0-4.5%. Given the low projected default, we expect spreads can remain at the lower end of their historical range. Ample access to capital and low borrowing costs are very positive for small cap equities.
4. Where we are finding the best stocks?
We are looking for stocks that are not fully discounting the recovery. Many companies we own will exceed 2019 earnings and revenues this year or next year, and yet are priced at valuations far below their pre-COVID-19 valuations. We also believe that these companies will significantly exceed investor expectations over the next two years. We see companies that meet this criteria in amusement parks, office furniture, regional gaming, retail, media, industrials and energy.
The views expressed are those of Spouting Rock Asset Management as of August 1, 2021 and are not intended as investment advice or recommendation. For informational purposes only. Investments are subject to market risk, including the loss of principal. Past performance does not guarantee future results. There can be no assurances that any of the trends described will continue or will not reverse. Past events and trends do not imply, predict or guarantee, and are not necessarily indicative of future events or results. Investors cannot invest directly in an index.