There’s still room for niche companies to do well, even in inflationary environments or volatile markets, if their products and services are specialized enough. Other important elements of quality include balance-sheet strength and cash-flow generation.
Nearly one-third of the companies in the Russell 2000 Index, a proxy for the U.S. small-cap equity market, are non-earners, or lower-quality firms that fail to demonstrate these characteristics. Low-quality companies may not have the financial wherewithal to manage their business in the face of more challenging macroeconomic conditions.
In particular, rising interest rates could threaten unprofitable, high-growth companies whose valuations have been supported by the low interest-rate environment that has persisted for the last decade or so.
Businesses characterized by elements of higher quality are more likely to be able to cope with higher inflation, ongoing supply-chain challenges and rising interest rates, even if they’re small. And within small caps, higher-quality companies are attractively priced compared to lower-quality companies.
So, the way we see it, smaller companies that fit the quality bill could have an edge over the balance of 2022 and beyond. While there are small-cap companies that meet these criteria across several sectors, we see great potential within technology and industrials, for example.
Within tech, many companies have high barriers to entry and sticky customer relationships. Software, in particular, could be attractive since it’s built into customer workflows and therefore is very difficult to replace. To a lesser extent, the same thing applies to semiconductors and related equipment. Semiconductors have been at the fore of the ongoing supply-chain disruptions, and capacity constraints have helped them with pricing power recently.
Certain areas of industrials also have attractive pricing power. These often come with a lag, but, generally, companies with differentiated products can help push higher prices onto consumers. The outlook for niche industrials with these unique products and limited competition could improve further as infrastructure investment increases. As this happens, they’ll be able to price for inflationary impacts.
The current market landscape is complicated. Inflation persists, interest-rates are on the rise and major geopolitical events, like the war in Ukraine, have thrown curveballs at a market that’s just emerging from a global pandemic and the attendant effects. But prudent investors can still find compelling opportunities among high-quality small-cap companies with durable business models and unique growth drivers—inflation or not.
Scott Conlon is senior equity investment specialist at abrdn.