Charlie Dreifus, CFA®—Royce Special Equity Fund
Having managed portfolios during the highly inflationary 1970’s, I believe those experiences have prepared me to be especially attentive to inflationary forces.
To that end, I see some good news and some not-so-good news in the current climate of greater inflation. The good news is that inflation is often a result of economic strength and thus reinforces the attractiveness of the value/cyclical spectrum of the market, where we are heavily weighted. Historically, cyclical value tends to outperform when inflation and interest rates rise, particularly if caused by improved business conditions. The not-so-good news is the potential for inflation absent economic growth—stagflation.
Increased inflation should cause interest rates to rise—another environment in which cyclical value names tend to do better than growth, but the market also faces a headwind if rates rise as it boosts the relative attractiveness of fixed income over equities. In addition, if inflation rises as the growth of money supply is being reduced while the economy remains strong, financial assets could be liquidated to fund the real economy. This is the opposite of what occurred earlier this decade, and more recently during the pandemic, when there was a flood of money supply but little to no demand for the increased liquidity in the real economy, thus inflating the prices of financial assets. (Those interested in learning more about this mechanism can refer to “Marshallian K.”)
Our goal in our portfolios is to own names that would potentially not suffer any ill effects from higher inflation. We use a disciplined value approach to buy inexpensive securities with little debt that generate ample free cash flow. These are also capital light businesses with a history of increasing their dividends—and all of these attributes have historically proven effective in inflationary periods. Last, but far from least, among these criteria, we look for companies in sectors where capacity has been reduced or removed—which gives them greater pricing power—another effective tool when inflation is rising.
Jim Stoeffel—Royce Opportunity and Micro-Cap Funds
At this point, we take the arguably contrarian stance that inflation is a temporary phenomenon related to the rapid reopening of the global economy and the attendant pressure on supply chains, which were effectively shut down by the pandemic. Two striking examples of the inflationary effect supply chain challenges are creating can be seen in the skyrocketing, record-high prices of lumber and used cars. We have holdings that have benefited from these increases. Pricing pressure—including labor, which remains in short supply—however, is currently pervasive across sectors and industries.
In the short term, we have been tactically adjusting position sizes based our view of a company’s ability to deal with increased pricing. The ability of our companies to increase prices and pass-through costs often depends on who their customers are. In general, we expect B2B companies to fare better than B2C over time as it’s possible consumers feel the pinch of inflation at some point. We have been net sellers of restaurant stocks, which face both labor and food cost pressures, while we view luxury brands, homebuilders, and advanced materials distributors as better positioned to pass through pricing.
So while inflation is very much with us, we look again to the lumber industry, where inflationary pressures appear to be subsiding a bit, as a possible harbinger. As such, we are already in the process of determining where we may see buying opportunities in the next three to six months as inflation fears abate.
Finally, we suspect inflation expectations could bifurcate. Industrial and precious metals, for instance, have been subject to years of underinvestment and have comparably long production lead times. As the global economy expands, we believe there will be significant increases in capital spending in these areas and therefore see select mining companies and their attendant suppliers as particularly interesting long-term investment opportunities.
Miles Lewis, CFA®—Royce Total Return, Pennsylvania Mutual, and Dividend Value Funds
Virtually every company we have spoken with recently seems to be seeing inflation—and all are talking about it. So, while we are bottom-up investors and do not make meaningful changes to our portfolios based on macro developments, we do listen closely to what the management teams of our holdings tell us.
Equally, if not more important, Total Return adheres to a disciplined philosophy of owning high-quality, dividend-paying stocks that we believe are undervalued. This bias typically leads us to companies with ample pricing power that are thus well equipped to handle inflation. For example, on a recent earnings call a company we hold mentioned ‘inflation’ 16 times and referenced ‘pricing’ 29 times in conveying confidence in its ability to pass on increased costs.
We believe that many holdings could benefit directly from inflation. We have been leaning into some of those stocks by adding to existing positions on the margin. Industrial distributors are one example. These businesses are poised to see a vibrant recovery as the economy expands but also tend to see their operating margins and earnings improve in an inflationary environment. Most distributors serve a smaller, more fragmented customer base and are thus able to quickly pass along higher prices from their suppliers—for example, industrial equipment manufactures. These price increases usually outpace the cost-inflation the distributor is experiencing, resulting in higher margins and earnings.
Another area that we believe can benefit from inflation are the regional and community banks we own. The link here is less direct—higher inflation often leads to higher rates and signifies strong economic growth, both of which would benefit the industry. Though the banks have had quite a run, we think they still represent attractive risk-reward, largely due to the potential for higher rates, driven in part by higher inflation.
Jay Kaplan, CFA®—Royce Small-Cap Value, Pennsylvania Mutual, and Capital Small-Cap Funds
There’s no question that inflation is here and is likely to grow. Ample liquidity and a rebounding economy are a perfect recipe for inflation. My view is that Fed policy will be key to managing its effects. The central bank’s target goal of 2% inflation before the question of easing or tapering remains reasonable. If the process of tapering is gradual, then I suspect that both the economy and markets should ultimately be OK. However, there’s always the risk that the Fed may try to do too much too quickly, which would impede economic growth and negatively impact share prices.
As for the market more specifically, there are critical issues that are both stoking inflation and leading to uncertainty about the earnings picture in 2022—earnings for 2021 should remain strong as they’re being measured off 2020’s recession. Among the most important challenges are those facing supply chains—the waiting times for appliances and other household items are several months long across most of the U.S. There are additional issues surrounding the majority of us going back to offices and/or getting back to work. How many of us return to offices and how frequently we commute are still open questions that will create ripple effects for restaurants, retail, and real estate.
In my portfolios, I’m most heavily weighted in Industrials, Consumer Discretionary, Financials, and Information Technology. My holdings in Industrials include companies that look well positioned to deal with current supply chain issues as well as those that appear more than capable of passing on costs in our inflationary environment. Constricted supply and high demand have led me to companies involved in household goods and furniture, where I anticipate sales should remain robust.
Financials are little trickier in that rising rates and a steeper yield curve should help banks, which are awash in cash (in large part based on PPE relief). Loan growth, however, remains weak. Of course, that could shift as the economy strengthens. Within technology, the ongoing semiconductor shortage is creating a ripple effect in which demand is outstripping supply in many industries such as auto manufacturing.
The chip shortage could last through the end of 2021. My tech positions are holding up well for now because they’re well capitalized and otherwise built to withstand the supply shortage. With demand unlikely to cool significantly, their long-term prospects look attractive to me.
The thoughts and opinions of Mr. Dreifus, Stoeffel, Lewis, and/or Kaplan concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
