Why I’m backing small caps now: Roger Montgomery

If inflation tapers as expected, history suggests the conditions are ideal for small innovative listed companies.

A period of modest economic growth combined with falling rates of inflation supports demand for shares in innovative growth firms like Bevan Slattery’s Megaport. Picture: Glenn Hunt

Back in the 1970s, macroeconomic research house Gavekal presented a slide revealing what investments do well in various combinations of growth and inflation. Their findings back then, which have stood the test of time, are innovative growth companies do well when the economy is growing and disinflation is occurring.

Disinflation, as distinct from deflation, is successive prints of lower rates of inflation. In other words, inflation might be 7 per cent today, then 6 per cent, then 5 per cent and so on. Disinflation and economic growth are the ideal environment for innovative growth companies to outperform on the stockmarket. Keep that in mind as you read on.

You may remember, last year, US Federal Reserve chair Jerome Powell postulated inflation might be transitory? Then, as inflation persistently surged towards 9 per cent, he was roundly criticised, ridiculed and pilloried for being dead wrong.

But now, it appears inflation may just be transitory after all. Indeed, commentators and investors appear to be convinced that Powell’s original assessment of inflation being “transitory” may prove prescient.

Consequently, stocks are rising and leading the charge are those high priced growth stocks.

If the recent spike in inflation does turn out to be transitory then the fear about a permanently higher plateau for inflation will be misplaced, and so too the lower stock prices that transpired.

Over the last 12 months I have written in this column, variously, that base effects of higher inflation rates would eventually be followed by disinflation. I have noted the massive investment in automation over the last five years and the lower levels of unionised labour would also set the stage for downward pressure on wage growth, which would also prove to put downward pressure on consumer prices. Lower inflation long term is therefore a reasonable expectation.

It has been a bumpy ride but markets are beginning to price in the idea the scenario most feared is unlikely to transpire. In the background, US money supply growth has slowed from nearly 30 per cent year-on-year to less than 7 per cent. Meanwhile, the annual change in US federal deficits as a percentage of GDP has also swung from near 15 per cent to negative 6 per cent. Together they suggest both monetary and fiscal policy settings in the US are restrictive.

Markets, of course, always take things to far: Some participants now believe central banks could cut rates next year. If too much optimism about this scenario creeps into prices, they will be set for another sell off when the Fed proves not to come though and instead, merely pauses its rate hikes, keeping rates at about their neutral setting.

Trying to guess where equities go requires an ability to guess what others will guess next. And that’s not investing.

Meanwhile, the bond markets are giving up on concerns about persistently, and historically, high rates of inflation. Investors are now pricing in a slowing in the pace of US rate increases. The sharp fall at the short end of the curve suggests investors now believe the inflation spike is transitory. If that’s the case, then Powell was right after all.

Lower long-term inflation expectations indicate prospects of a reversion to a low inflation and disinflationary environment. If that is the case, then the best relative place to invest in equities is in smaller growth companies.

Putting my money where my mouth is, a month or two ago I made an additional contribution to Polen Capital’s Small and Mid-sized Company Fund. I did the same again last week. After making such investments it is my hope prices fall further. That’s partly because I would otherwise regret not having invested more. It also is a reflection of the fact I just don’t know where the bottom is, and I am no good at predicting these things.

What I do know is that investing frequently when prices for quality equities reflect a lack of popularity is precisely the right thing to do.

Inflation fears are now giving way to the possibility inflation has peaked. What follows could be a period of modest economic growth combined with falling rates of inflation.

Since at least the early 1970s such environments have supported demand for shares in innovative growth companies. In Australia that means the sort of companies we have discussed such as the Bevan Slattery-chaired networking group Megaport, Macquarie Telecom and cloud computing group Symbio Holdings.

Globally, it is quality growers like Adobe, Fever Tree, Yeti, Musti and Five Below that have the characteristics investors have historically turned to when growth and disinflation abound.

Roger Montgomery is chief investment officer at Montgomery Investment Management