James Gowen, CFA, Chief Investment Officer, Small Cap Growth
September 7, 2021
Last month, our colleagues at Penn Capital Management wrote about inflation and the ongoing debate as to how transitory its effects may be, including the possible impact on small cap performance. With the hindsight now of a full earnings season, we found that most of our holding’s management teams mentioned inflation during their earnings calls, referring either to its effects on wages or input costs. Also prominent were discussions on supply chains and lead times to source various products from semiconductors to raw materials. We reviewed many of the Federal Reserve’s comments and views on inflation and our read of their definition of “transitory” seems to indicate that prices will not be going back to previous levels, but instead may not rise at the same speed we have seen of late — obviously considerably different things! Investors were also keenly focused on the recent Jackson Hole meeting, but it seems the “tea leaf” reading in the aftermath left most opinions unchanged.
While we do not believe our team’s skills as macro economists set us apart and therefore focus on building portfolios from the bottom up, we do realize we cannot fully divorce ourselves from all macro effects, even if minor. Therefore, in this current environment, our job as portfolio managers is also to make sure that the companies we own and are researching for potential ownership are not overly exposed to higher external risks including inflation effects. We are finding that those companies with truly differentiated products and services, those demonstrating faster growth and higher competitive dynamics and pricing power are, to date, better weathering the early effects and actually might even garner higher relative valuations, though we are not changing our price targets.
In the small cap space, we saw earnings for the second quarter and the forward outlooks that were mostly quite positive, although market reactions to stock prices seemed a bit more muted than we have seen historically, perhaps a result of investor’s general concerns over the emergence of the Delta variant, a lackluster consumer sentiment report that negatively surprised Wall Street and a bit more global uncertainty caused by recent events in Afghanistan.
As we take a biased look around at the alternatives, we see very low potential returns in traditional 60/40 portfolios, especially on a real return basis after inflation, and feel investors will have to migrate to areas of higher potential return to achieve their goals. We remain enthused as to the prospects for active equity management and the ability to control risk relative to passive strategies. The favorable positioning of smaller companies that possess the ability to outgrow, out-innovate and out-compete larger competitors should remain attractive. We see the pace of disruption and innovation continue to accelerate coming out of the COVID-19 induced dislocations. New markets and new opportunities are being created by the pivot to digital adoption across multiple industries and sectors and areas such as clean energy and electric vehicles as just a few examples. Technology touches every company we own regardless of the sector they operate in and has become a vital competitive tool and a core component of our research and analysis.
The views expressed are those of Spouting Rock Asset Management as of September 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.