Why do small caps outperform during inflation?

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traderlmd
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Why do small caps outperform during inflation?

Post by traderlmd »

It seems like it'd be literally the exact opposite.

It's said that, during periods of high inflation, companies with pricing power generally outperform. That seems like the opposite of small caps though. It seems like, in the face of rising prices, consumers would be more comfortable buying from companies with strong brand recognition which just isn't small caps. Yet history has shown that time and time again small caps usually outperform during periods like this. What't the reason for that?
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willthrill81
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Re: Why do small caps outperform during inflation?

Post by willthrill81 »

traderlmd wrote: Mon May 03, 2021 2:02 pmIt seems like, in the face of rising prices, consumers would be more comfortable buying from companies with strong brand recognition which just isn't small caps.
I don't follow your reasoning here at all. Why would high inflation make brand recognition more impactful on consumers than would low inflation?

Further, consumer facing brands where such recognition would be impactful is only a relatively small portion of all large-caps.
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Re: Why do small caps outperform during inflation?

Post by vineviz »

traderlmd wrote: Mon May 03, 2021 2:02 pm It seems like it'd be literally the exact opposite.

It's said that, during periods of high inflation, companies with pricing power generally outperform. That seems like the opposite of small caps though. It seems like, in the face of rising prices, consumers would be more comfortable buying from companies with strong brand recognition which just isn't small caps. Yet history has shown that time and time again small caps usually outperform during periods like this. What't the reason for that?
Small caps will tend to outperform during periods of strong economic growth since smaller companies tend to both have higher financial leverage and be more exposed to cyclical (i.e. economically sensitive) industries.

Inflation tends to be more robust during periods of strong economic growth as well, so it may appear that inflation is "good" for smaller companies when inflation itself isn't that big a factor.
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traderlmd
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Re: Why do small caps outperform during inflation?

Post by traderlmd »

willthrill81 wrote: Mon May 03, 2021 2:09 pm
traderlmd wrote: Mon May 03, 2021 2:02 pmIt seems like, in the face of rising prices, consumers would be more comfortable buying from companies with strong brand recognition which just isn't small caps.
I don't follow your reasoning here at all. Why would high inflation make brand recognition more impactful on consumers than would low inflation?
I'm not sure. I was just assuming because I thought that if prices suddenly rose, that a consumer would be more likely to be willing to cough up the extra cash for a known and trusted brand. What's your opinion?
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Re: Why do small caps outperform during inflation?

Post by Seasonal »

traderlmd wrote: Mon May 03, 2021 2:02 pm It seems like it'd be literally the exact opposite.

It's said that, during periods of high inflation, companies with pricing power generally outperform. That seems like the opposite of small caps though. It seems like, in the face of rising prices, consumers would be more comfortable buying from companies with strong brand recognition which just isn't small caps. Yet history has shown that time and time again small caps usually outperform during periods like this. What't the reason for that?
What's your source for this?

According to https://www.cmegroup.com/education/feat ... lence.html "Since 2010, small-cap stocks have outperformed large caps during periods of rising inflation expectations and vice versa. 2020 was no exception. Looking further back -- the Russell 2000’s data history begins in 1979 – the performance of small and large-cap stocks have roughly been similar."
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Re: Why do small caps outperform during inflation?

Post by willthrill81 »

traderlmd wrote: Mon May 03, 2021 2:44 pm
willthrill81 wrote: Mon May 03, 2021 2:09 pm
traderlmd wrote: Mon May 03, 2021 2:02 pmIt seems like, in the face of rising prices, consumers would be more comfortable buying from companies with strong brand recognition which just isn't small caps.
I don't follow your reasoning here at all. Why would high inflation make brand recognition more impactful on consumers than would low inflation?
I'm not sure. I was just assuming because I thought that if prices suddenly rose, that a consumer would be more likely to be willing to cough up the extra cash for a known and trusted brand. What's your opinion?
If anything, I would think that the opposite would be true. To the extent that the old (i.e., uninflated) price serves as an anchor of future prices, consumers might prefer smaller brands with lower inflated prices over larger brands with higher inflated prices. For instance, after 5% inflation, both big brand A and small brand B go up in price by 5%. But if small brand B was $10 beforehand and big brand A was $12, small brand B will only go up in price by 50 cents, whereas big brand A will go up in price by 60 cents. Rationally, the new inflation-adjusted prices are the same, but we know that consumers seldom react to such prices in a purely rational way.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
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Re: Why do small caps outperform during inflation?

Post by willthrill81 »

vineviz wrote: Mon May 03, 2021 2:15 pm
traderlmd wrote: Mon May 03, 2021 2:02 pm It seems like it'd be literally the exact opposite.

It's said that, during periods of high inflation, companies with pricing power generally outperform. That seems like the opposite of small caps though. It seems like, in the face of rising prices, consumers would be more comfortable buying from companies with strong brand recognition which just isn't small caps. Yet history has shown that time and time again small caps usually outperform during periods like this. What't the reason for that?
Small caps will tend to outperform during periods of strong economic growth since smaller companies tend to both have higher financial leverage and be more exposed to cyclical (i.e. economically sensitive) industries.

Inflation tends to be more robust during periods of strong economic growth as well, so it may appear that inflation is "good" for smaller companies when inflation itself isn't that big a factor.
Interesting idea. So inflation and small cap outperformance are presumably both caused by strong economic growth and are not directly related to each other in a significant way. That makes sense.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
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Re: Why do small caps outperform during inflation?

Post by msw1 »

I am not sure about small caps in general, but if you are wondering about the correlation between small cap value and inflation, Bill Bernstein wrote an old post about this: http://www.efficientfrontier.com/ef/701/value.htm
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Re: Why do small caps outperform during inflation?

Post by traderlmd »

willthrill81 wrote: Mon May 03, 2021 2:56 pm
traderlmd wrote: Mon May 03, 2021 2:44 pm
willthrill81 wrote: Mon May 03, 2021 2:09 pm
traderlmd wrote: Mon May 03, 2021 2:02 pmIt seems like, in the face of rising prices, consumers would be more comfortable buying from companies with strong brand recognition which just isn't small caps.
I don't follow your reasoning here at all. Why would high inflation make brand recognition more impactful on consumers than would low inflation?
I'm not sure. I was just assuming because I thought that if prices suddenly rose, that a consumer would be more likely to be willing to cough up the extra cash for a known and trusted brand. What's your opinion?
If anything, I would think that the opposite would be true. To the extent that the old (i.e., uninflated) price serves as an anchor of future prices, consumers might prefer smaller brands with lower inflated prices over larger brands with higher inflated prices. For instance, after 5% inflation, both big brand A and small brand B go up in price by 5%. But if small brand B was $10 beforehand and big brand A was $12, small brand B will only go up in price by 50 cents, whereas big brand A will go up in price by 60 cents. Rationally, the new inflation-adjusted prices are the same, but we know that consumers seldom react to such prices in a purely rational way.
Oh wow, that's really interesting. Thanks for the response.

So I guess that this implies larger companies currently have larger margins (and I think this is the case, correct?), and that they would have a harder time maintaining their current margins in an inflationary environment than would their narrower margin small-cap counterparts?
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Re: Why do small caps outperform during inflation?

Post by hi_there »

I think the rule of small caps outperforming during inflation/growth is tenuous, given that FAANG has completely dominated Russell 2000 since 2008. "It is not your grandfather's market" so to speak, since rapid expansion potential and long term payouts have increasingly been associated with mega caps.
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Re: Why do small caps outperform during inflation?

Post by VTI »

traderlmd wrote: Mon May 03, 2021 5:30 pm So I guess that this implies larger companies currently have larger margins (and I think this is the case, correct?), and that they would have a harder time maintaining their current margins in an inflationary environment than would their narrower margin small-cap counterparts?
Something to keep in mind: "Small-cap" companies aren't actually small. For example, the median market cap in Vanguard's small-cap index fund is six billion dollars.

When most people think of small, nimble companies, they're not thinking about multi-billion-dollar enterprises.
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Re: Why do small caps outperform during inflation?

Post by secondopinion »

VTI wrote: Mon May 03, 2021 5:42 pm
traderlmd wrote: Mon May 03, 2021 5:30 pm So I guess that this implies larger companies currently have larger margins (and I think this is the case, correct?), and that they would have a harder time maintaining their current margins in an inflationary environment than would their narrower margin small-cap counterparts?
Something to keep in mind: "Small-cap" companies aren't actually small. For example, the median market cap in Vanguard's small-cap index fund is six billion dollars.

When most people think of small, nimble companies, they're not thinking about multi-billion-dollar enterprises.
They need a Vanguard micro-cap fund. Even then, the companies will still be larger than what they think.
It is better to be half-wrong than have a 50% chance of being all-wrong. With the former, you will learn and have money to try again. Otherwise, you will never learn and will have nothing eventually.
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Re: Why do small caps outperform during inflation?

Post by dboeger1 »

willthrill81 wrote: Mon May 03, 2021 2:56 pm
traderlmd wrote: Mon May 03, 2021 2:44 pm
willthrill81 wrote: Mon May 03, 2021 2:09 pm
traderlmd wrote: Mon May 03, 2021 2:02 pmIt seems like, in the face of rising prices, consumers would be more comfortable buying from companies with strong brand recognition which just isn't small caps.
I don't follow your reasoning here at all. Why would high inflation make brand recognition more impactful on consumers than would low inflation?
I'm not sure. I was just assuming because I thought that if prices suddenly rose, that a consumer would be more likely to be willing to cough up the extra cash for a known and trusted brand. What's your opinion?
If anything, I would think that the opposite would be true. To the extent that the old (i.e., uninflated) price serves as an anchor of future prices, consumers might prefer smaller brands with lower inflated prices over larger brands with higher inflated prices. For instance, after 5% inflation, both big brand A and small brand B go up in price by 5%. But if small brand B was $10 beforehand and big brand A was $12, small brand B will only go up in price by 50 cents, whereas big brand A will go up in price by 60 cents. Rationally, the new inflation-adjusted prices are the same, but we know that consumers seldom react to such prices in a purely rational way.
If incomes don't increase proportionally and households aren't sufficiently exposed to marketable securities, then nominal differences are actually quite rational. I would say that describes a huge portion of American households year-over-year.
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Re: Why do small caps outperform during inflation?

Post by 3CT_Paddler »

VTI wrote: Mon May 03, 2021 5:42 pm
traderlmd wrote: Mon May 03, 2021 5:30 pm So I guess that this implies larger companies currently have larger margins (and I think this is the case, correct?), and that they would have a harder time maintaining their current margins in an inflationary environment than would their narrower margin small-cap counterparts?
Something to keep in mind: "Small-cap" companies aren't actually small. For example, the median market cap in Vanguard's small-cap index fund is six billion dollars.

When most people think of small, nimble companies, they're not thinking about multi-billion-dollar enterprises.
A billion dollars isn’t what it once was. A company that does software in the civil engineering world with 200 employees and $30 million in sales just went for $1 billion.
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Re: Why do small caps outperform during inflation?

Post by willthrill81 »

traderlmd wrote: Mon May 03, 2021 5:30 pm
willthrill81 wrote: Mon May 03, 2021 2:56 pm
traderlmd wrote: Mon May 03, 2021 2:44 pm
willthrill81 wrote: Mon May 03, 2021 2:09 pm
traderlmd wrote: Mon May 03, 2021 2:02 pmIt seems like, in the face of rising prices, consumers would be more comfortable buying from companies with strong brand recognition which just isn't small caps.
I don't follow your reasoning here at all. Why would high inflation make brand recognition more impactful on consumers than would low inflation?
I'm not sure. I was just assuming because I thought that if prices suddenly rose, that a consumer would be more likely to be willing to cough up the extra cash for a known and trusted brand. What's your opinion?
If anything, I would think that the opposite would be true. To the extent that the old (i.e., uninflated) price serves as an anchor of future prices, consumers might prefer smaller brands with lower inflated prices over larger brands with higher inflated prices. For instance, after 5% inflation, both big brand A and small brand B go up in price by 5%. But if small brand B was $10 beforehand and big brand A was $12, small brand B will only go up in price by 50 cents, whereas big brand A will go up in price by 60 cents. Rationally, the new inflation-adjusted prices are the same, but we know that consumers seldom react to such prices in a purely rational way.
Oh wow, that's really interesting. Thanks for the response.

So I guess that this implies larger companies currently have larger margins (and I think this is the case, correct?), and that they would have a harder time maintaining their current margins in an inflationary environment than would their narrower margin small-cap counterparts?
Yes, larger brands generally have better brand knowledge (i.e., awareness and image) and consequently can charge a higher premium over other brands. Paradoxically to the 'homo economicus' perspective, the brands with the largest market share often have among the highest margins in the market. But in the above scenario, smaller brands on the 'fringes' may have a significant advantage.
dboeger1 wrote: Mon May 03, 2021 6:29 pm If incomes don't increase proportionally and households aren't sufficiently exposed to marketable securities, then nominal differences are actually quite rational. I would say that describes a huge portion of American households year-over-year.
That's an excellent point.

My dad told me about working through the rampant inflation of the 1970s, and the hospital he worked for gave raises every six months to try to help people keep pace, but it wasn't enough. Before the six months were up, many were really feeling the crunch.
“Good and ill have not changed since yesteryear; nor are they one thing among Elves and Dwarves and another among Men.” J.R.R. Tolkien, The Lord of the Rings
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Re: Why do small caps outperform during inflation?

Post by Alchemist »

I think you guys are over thinking this. My assumption has always been that two things were going on:

1) Small cap companies tend to have high debt loads. Inflation makes those debts smaller and easier to deal with

2) Alot of regional banks and other financial institutions in the small cap space. High inflation means high interest rates, higher interest rates mean higher earnings for financial companies
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Re: Why do small caps outperform during inflation?

Post by SCb&b »

Not sure about small cap but my understanding is value does better in high expected inflation because profits are expected now and not subject to future inflation as much. Growth companies are priced based on expected profits in the future but with inflation these profits will be eroded which decreases price.
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Re: Why do small caps outperform during inflation?

Post by traderlmd »

Alchemist wrote: Tue May 04, 2021 4:05 am I think you guys are over thinking this. My assumption has always been that two things were going on:

1) Small cap companies tend to have high debt loads. Inflation makes those debts smaller and easier to deal with

2) Alot of regional banks and other financial institutions in the small cap space. High inflation means high interest rates, higher interest rates mean higher earnings for financial companies
Oh wow. Great points. Is there any metric out there that shows the average debt load of companies in the S&P/Russell 2000?
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