Small-Cap Outperformance since the Election and Shareholder Yield
Small- and mid-cap stocks have outperformed their large-cap brethren since the election. Between November 8 and March 6, the Russell 2500 Index has returned 14.5%, while the S&P 500 Index has returned 11.8% (see chart below). Can the upward move persist? We checked in with Portfolio Manager, Michael Caputo, who advises MainStay Epoch U.S. Small Cap Fund, to compare notes.
President Trump campaigned on reduced taxes, rolled-back regulation, more spending on infrastructure, better trade deals, border security, replacing the Affordable Care Act, and upgrading the military. He vowed the fastest U.S. economic growth in years. In the view of Caputo and his colleagues, the market likes the stimulus, but can do without protectionism.
Small-cap stocks generally have higher domestic revenue shares than do large-cap stocks, and thus, should have more to gain – all else being equal – from a stronger domestic economy, according to Caputo. Small-cap companies typically pay a higher tax rate than larger-cap companies with more international revenues, so any cut in the corporate tax rate would be a greater benefit to small-cap companies. What’s more, the more domestic orientation of small-cap stocks leaves them less exposed to potential protectionism, which the team views as a possible source of risk. Finally, small-cap stocks also typically have higher betas, and thus, frequently perform well in pronounced market advances.
Small Caps Have Outperformed since the Election
Source: Bloomberg, data as of 3/7/17. Last data point, 3/6/17. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Small-Cap Investment Opportunity Set
However, over time, Caputo argues it comes down to the generation of cash flow and the allocation of capital towards its best uses by shareholder-friendly company management teams. Given how Wall Street firms have pared back their research coverage of small- and mid-cap stocks, Caputo believes there is an even greater opportunity for practitioners of Epoch’s research-oriented, free-cash-flow approach. The team keeps at least 80% of its holdings in stocks with a market cap of $6 billion or less.
Where is the team finding opportunity? Although each holding is selected via a bottom-up process, the result of this exercise is an overweight position in consumer stocks with strong brands, and with a bent towards experience-oriented discretionary spending. The team is also overweight names in the technology and industrial sectors, while being underweight sectors such as utilities and real estate investment trusts (REITs). The team’s focus on steady cash flow growth leaves it underweight the energy sector, where supply appears ample and earnings often cycle up and down with commodity prices.
Headwinds to Consider
The market has had a nice run since the election. Part is earned on stronger economic growth of late, but part of this is on the promise of things to come, in Caputo’s view. The new administration and Congress will need to deliver on items, such as tax cuts and infrastructure spending, to keep investors viewing the period ahead from a “half-full” perspective. At 19 times expected 2017 earnings-per-share and 18 times expected 2018 earnings-per-share for the profitable companies in the universe Caputo invests in, the market is not overvalued, per se, but it is fully valued, with limited room for disappointment.
Profit growth and the prospect for business-friendly fiscal policies leave Caputo and his colleagues optimistic about the future for those firms able to generate cash flow and allocate it wisely.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
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