Interest rates are going higher, there’s no denying it…
The Bank of Canada and the U.S. Federal Reserve both raised their key rates for the first time since 2018 this month, and all signs point to further hikes.
Coupled with abnormally high ‘transitory’ inflation (particularly expensive oil) – investors are taking a cautious approach to the markets, particularly if these factors could lead to recessionary pressures.
The question on investors’ minds is: how to best position your portfolio during periods of interest rate hikes?
Due to high inflation, historical outperformance of equities in rising rate environments and comparatively attractive valuations, I believe that 2022 will be another strong year; particularly for small-cap returns.
In this article I will outline why I believe that is the case, while also providing some of the attributes that are going to become increasingly important when selecting growth stocks for your portfolio this year.
Spoiler – I am not bullish on the small-cap sector as a whole! There will be lots of carnage in the sector I have no doubt.
Rising inflation requires a more aggressive portfolio to profit
According to Bankrate’s March 23, 2022 weekly survey of American financial institutions, the national average interest rate for savings accounts is 0.06 percent.
I re-read that a few times out of disbelief, before checking my own accounts…
Sure enough, my RBC “High Interest e-savings” account delivers me a juicy 0.05% every year! Which means for every $1,000 I have “invested”, I earn $0.50 cents annually…enough to pay for the new “paper cup fee” introduced in Vancouver, BC Starbucks this year…
With inflation most recently recorded at 7.9% per year, that means my savings account is effectively losing 7.85% for the “safety” that the big banks tout as so compelling.
Over the last 30 years, average equity returns hovered around 10%, meaning that even an entirely stock focused portfolio will just barely squeeze out a profit after accounting for inflation!
Better than bonds, much better than savings accounts, but still nothing close to what is required to create actual wealth.
Tell this to a Gen Z and they’ll quickly show you that their 3000% return on their Sleepy Donkeys NFT collection easily outpaced this so called “inflation”.
Though I’m generally an advocate for high torque investing, most NFT projects are way too much spice for my portfolio.
So for now, let’s keep our focus on growth stocks, and where we can find the best risk/reward to outpace inflation, keep growing those accounts, and avoiding overpriced Jpegs as much as possible.
Stocks have historically performed well after rate hikes
When reviewing historical data, rising interest rate environments are actually overwhelmingly positive for equities.
In the 12-months following the previous eight interest rate hikes, equities saw an increase in their value 100% of the time…
Though historical performance is no perfect indicator of future performance…I’m liking what I see in the chart above.
Generally speaking, interest rates are increased in an effort to cool off an overheating economy that is experiencing high inflation.
That means that at the core of the economy, things are humming along nicely for the majority of companies that comprise our stock indexes.
Now in particular, and what I’ve found most interesting about this research, is that small-cap stocks have outperformed their large-caps peers historically in rising rate environments.
The broadest and most well-known index we have that covers small-caps is the Russell 2000 (RUT), which in spite of short term volatility immediately after rate hikes, returns over 12-, 18- and 36-months have been exceptionally strong.
Goldman Sachs analysts were recently on record as stating:
“We believe small-cap stocks can continue to outperform in 2022. The expectation for earnings growth of Russell 2000 companies in 2022 is 30%, well above the 9% forecast for the S&P 500”
Small-cap valuations are comparatively attractive
To speak plainly on the current state of small-caps….
“It’s been a bloodbath,” said Steven DeSanctis, a small and mid-cap equity strategist at Jefferies. “The average small-cap stock is down about 40% from its 52-week high.“
If you’re a micro-cap investor like myself, the pain has been even more acute.
However at this point, I really do feel like most of the pain is behind us (hopefully not my famous last words…).
I would rather have a good company at a great valuation, than a great company at a premium valuation – and I’m seeing a lot of great valuations out there.
In reviewing the Fact Sheet for the S&P 500, the S&P 600 small-cap index, and the S&P 600 “Quality” index (which filters down to the 118 highest quality small-cap issuers)…the valuations start to tell a particularly compelling story.
The trailing PE ratios as at Feb 28, 2022 are as follows:
S&P 500: 24.56
S&P 600: 26.67
S&P 600 ‘Quality’: 16.85
The forward estimated PE ratios as of the same date are:
S&P 500: 19.56
S&P 600: 14.48
S&P 600 ‘Quality’: 12.13
According to Wells Fargo’s head of equity strategy, Christopher Harvey, the average stock in the S&P Small-Cap 600 Quality Index typically trades at a significant premium to lower-quality small-caps.
Today, it does not…
In plain English: The highest quality small-caps in the U.S. currently trade at a discount to their lower quality peers on both a current price to earnings basis, and forward looking.
This data comes from S&P’s website, but given the “too good to be true” nature of these figures, if anyone reading this has access to other data sources, please double check and let me know what you find!
How am I positioning my portfolio?
There are three things that I am taking away from all of this.
First of all, I will be allocating more capital to small-cap stocks that have recently experienced substantial pullbacks as a whole.
Specifically I am going to focus (for now anyways) on the highest quality issuers in the S&P600 Quality index (SP600).
Companies with solid earnings growth, minimal debt, cash on their balance sheet and stable revenue sources.
Don’t feel like doing research?
The Invesco S&P Small-Cap Quality ETF trades with the ticker symbol (XSHQ).
I’ll likely be buying a chunk of that and adding it to my Tax Free Savings Account (TFSA).
The second thing I will do is dig a bit deeper into micro-cap stocks, trying my best to find some higher quality issuers that check similar boxes to the quality stocks mentioned above.
I’ll be less demanding with my requirements, but I would like to see growing revenues, minimal debt and cash on their balance sheets so that they don’t require a near term financing.
The quality of the revenue needs to be good as well. This means consistency (bonus points for recurring), and not from one-off transactions.
While small-caps are down roughly 40% from their highs, micro-caps have been beaten to a pulp.
There are lots of attractively valued companies out there right now, and many jittery investors on the sidelines.
Do you have any micro or small-cap stocks you think check some of these boxes? I would LOVE for you to share them with me!
The third thing I will do… is wait.
I am in absolutely no rush. As mentioned above, the first quarter after a rate hike is historically shaky.
The most boring investing strategy of all time still rings true today…. dollar cost averaging.
I will take my time researching companies and slowly add them to the portfolio one by one. My cash balance is at a historical high right now, so I am loaded with dry powder to start making some moves.
What are you buying?
This newsletter is written by Kevan Matheson, Founder & CEO of Edge Investments.
Prior to starting Edge, Kevan was an Institutional Analyst at RBC Global Asset Management, one of North America’s largest fund managers, with assets under management in excess of $400 billion.
After spending the majority of his career focused on large market capitalization public companies, Kevan became attracted to the risk/reward proposition of growth stocks and cryptocurrency.
In 2017 Kevan published a book on investing in cryptocurrency, where he speculated on the coming growth in NFT’s and the underlying tokens that power their ecosystems.
Known in the growth stock community as Small Cap Kev, his current passion is finding stocks in disruptive industries like blockchain, psychedelic medicine, plant-based meat alternatives & much more.