As we continue to climb out from the effects of the global quarantine, the post-Covid world for earnings and economic growth is becoming more apparent. The International Monetary Fund (IMF) has upgraded its 2021 global growth estimate to 6%, boosted by the $1.9-trillion fiscal stimulus in the US.
In general, the acceleration in fiscal spending across most big economies since the start of the pandemic has contained the number of bankruptcies, restrained the increase in unemployment and reduced economic scarring
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 past 10 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 when they have pricing power. Warren Buffett once said: “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a good business. And if you need a prayer session before raising the price by a 10th 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 and 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 0.2% of the FTSE/JSE all share index.
The IMF Global Financial Stability Review provides a risk-based framework to evaluate pricing power by evaluating liquidity, solvency and viability measures.
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 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 the travel and leisure sector have a quick ratio of 0.6 — an indicator of high liquidity risk and poor financial health.
Solvency is defined as the ability of a company to meet 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 compared with equity are better insulated from failure. Most companies have capitalised on the low interest rate environment and high market valuations to raise equity capital and shore up their balance sheets. However, travel and leisure’s debt-to-equity ratio is 4.9, once again an indicator of extremely poor financial health.
Viability assesses whether a company or sector will be profitable within three years 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. The prospects for the sector are unlikely to improve as tourism is expected to remain subdued until the pandemic is brought under control everywhere. Pandemic-related restrictions on international travel and a more general fear of travelling are expected to have lasting effects on economic activity within the sector — an indication of ailing viability for the industry.
Small caps have historically been a good inflation hedge, particularly during early economic expansion phases when interest rates rise. However, the post-Covid world will be characterised by an uneven recovery at a sector level. Not all small caps will be able to provide inflation hedge qualities. Pricing power is critical, and investors need to apply a selective approach to avoid stocks with ailing viability and poor financial health, such as those in the travel and leisure sector.
• Ndinavhushavhelo Rabali is chief investment officer at Lima Mbeu Investment Managers
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