At the Montgomery Small Companies Fund, our small caps team’s approach is to invest in businesses that benefit from supportive underlying themes. Two themes we like right now are what we call Stable Compounders and Structural Winners. And we have two preferred stocks – one in each theme – that we think will provide solid long-term returns.
Is inflation really a risk?
At the commencement of the year pundits claimed inflation would emerge to slay the high investment returns recently enjoyed. On cue, volatility rose. But danger’s partner is opportunity, and investors who took advantage of the minor market set back were promptly rewarded.
Our stance on the question of inflation is simple but structural. Money supply has been rising at an exponential rate since the 1960s and yet, since 1980, inflation has been in decline. I was taught at university that the positive correlation between the two was immutable, but the real world has again proven a theory wrong.
I believe there are two fundamental and structural reasons for this. First, unionised labour is a fraction of what it was just three decades ago. Large collectively negotiated annual wage increases are a thing of the past. In the US, a similar lid on wages exists due to the level of unionised labour declining precipitously in recent decades. When wage growth is low, a large component of the pressure on consumer prices is removed.
Second, while we’ve all been talking about COVID-19 vaccinations and reopening, the world has been investing a record amount in technology, and in particular, automation. Automation displaces labour, hammering another nail in the coffin of wage growth.
And as we reach 90 per cent vaccination coverage, and international borders reopen, the return of immigration will reduce current competition for skilled workers and the associated pressures on salaries in some industries.
If inflation is structurally lower, investors can be more comfortable with the prospect of lower interest rates and perhaps even negative real rates. Real rates are the difference between nominal interest rates and inflation. They have been negative in the US for some time, rendering equities and other assets particularly attractive. With inflation potentially in check structurally, nominal rates then remain low and real rates potentially remain negative.
It’s not great for those relying on income from cash deposits but it’s potentially good news for every other investment.
And elsewhere, the economy is cooling. In the US for example, the impulse of economic activity immediately following the COVID-19-inspired slowdown, is itself starting to ease. US unemployment benefits are now being scaled back and it has been reported some seven million people have had their unemployment benefits cut to zero. Another three million have seen their employment benefits cut by US$300 per week.
While investors may be more excited about the negative influence this potentially has on consumer demand and therefore consumer prices, a less obvious impact will come from these people gaining employment. An increase in labour supply will also place downward pressure on wages.
And while you wouldn’t know it right now, looking at price increases in the energy commodity complex, cooler global growth should limit further price gains and ultimately lead to lower inflation, while keeping bond yields capped. Meanwhile, a slowing demand, which is usually associated with declining rates of economic growth, will also provide room for supply chains to catch up and for the concurrent inflationary bottlenecks to ease.
Should the current trends endure, investors can remain reasonably confident that conditions, which have hitherto been supportive for equities, will also continue.
A focus on two strong underlying themes
Of course, that does not mean investors can take a random approach to owning equities. Instead, one appropriate approach should involve acquiring businesses that benefit from supportive underlying themes.
In the Montgomery Small Companies Fund, we have labelled one such theme, Stable Compounders. These are businesses offering growth with a defensive element, they tend to be in stable industries, are market leaders and are under appreciated by the market. A Stable Compounder is high quality, commands a superior competitive position and a strong management team capable of delivering a sensible strategy. These companies are also typically at the cashflow-harvesting stage of their lifecycle.
One example of such a business is Waypoint REIT (ASX:WPR), which owns Australian petrol station sites leased to the likes of 7Eleven, Liberty, and the Shell/Coles Express convenience chain. Waypoint properties enjoy 100 per cent occupancy, a 10.5-year weighted average lease expiry (WALE) and 3 per cent weighted average rent reviews. WPR yields slightly more than 5 per cent, which along with an estimated dividend per share growth equivalent to about 3 per cent, offers a potential total shareholder return of 9 per cent.
Management also announced a $150 million capital return buyback on 30 July 2021 which is subject to the settlement from the sale of a portfolio of properties expected to occur this half.
Additionally, the potential for further revaluations exists with WPR’s book of properties appearing to be valued 20 per cent below the prices similar properties are being transacted for in the open market.
Finally, Waypoint’s internally managed structure, along with an open share register, potentially renders it attractive as an acquisition in a sector where mergers appear to be just taking off.
A second theme we believe will assist investors to generate at least relatively better returns is a theme we call Structural Winners. This theme also offers investors the ability to be agnostic with respect to the state of the economy.
Structural Winners are businesses benefitting from global megatrends, such as cloud computing or decarbonisation. For the latter we mean the shift from fossil fuels to renewable electricity and hydrogen technology. With Australia blessed with all of the raw materials required for lithium-ion batteries, investors have the opportunity to invest in a once-in-a-generation shift in transportation and energy storage.
Structural Winners are also businesses with long runways for growth, take market share from weaker or legacy incumbents and are therefore in control of their own destiny. A business like Macquarie Telecom (ASX:MAQ) run by David Tudehope is also a company whose shares we own. A data centre operator, it benefits from the trend toward cloud services, which is levelling the playing field for small businesses to compete globally and digitally. As the company expands its footprint, the market is also slowly understanding it can sell its last 10 per cent of capacity for 10 times the price of its first 90 per cent. And whether the economy grows or not probably matters little.
In an environment of slow but steady economic growth and disinflation, the best companies to invest in have historically been innovative companies offering growth. The Structural Winners thematic has rewarded investors over the last 10 years and may continue to do likewise over the next decade. We currently believe, notwithstanding the ever-present risk of a 10-15 per cent set back, financial year 2022 will prove to be as lucrative as FY21.
The Montgomery Small Companies Fund owns shares in Macquarie Telecom. This article was prepared 28 October 2021 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Macquarie Telecom you should seek financial advice.