Small Companies, Big Opportunities?
Small-cap stocks rapidly appreciated on an absolute and relative basis, following the 2016 U.S. presidential election. Trump’s victory and an onslaught of positive economic data pushed up investor sentiment and the prospects for faster growth, particularly at home – a tailwind for higher beta, domestic stocks like small caps. Since then, U.S. small caps have struggled relative to their large cap peers (Figure 1). A weaker showing, however, has created a potential buying opportunity.
Figure 1: Small-Cap Equities Slow in the First Half of 2017
Source: Bloomberg, as of 7/11/2017.
Most importantly, the global economy remains on solid footing, posting impressive signs of growth both at home and abroad. The Institute for Supply Management’s (ISM) June survey rebounded to 57.8 in the United States, which signals that business conditions remain very robust. A strong economy at home and abroad is unequivocally supportive of risk assets. Small-cap stocks have historically had higher betas1, and therefore, frequently perform well in pronounced market advances.
Small-cap stocks look particularly attractive, as earnings growth expectations have turned more favorable versus this time last year (Figure 2). We believe any increase in the U.S. dollar from here would also likely further favor small-cap earnings, since their revenues tend to be more domestically oriented. Additionally, improvements in corporate liquidity, higher valuations, and late-cycle economics tend to be a positive driver of merger and acquisition (M&A) activity, which may bode well for small-cap stocks.
Figure 2: Small-Cap Earnings Growth Expectations Look Favorable
Source: Thomson Reuters Datastream, as of 7/11/2017. Earnings-per-share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock.
The current mainstream expectations suggest that President Trump’s agenda is completely derailed, and recent developments only serve to intensify this view. The release of a series of e-mails by Donald Trump Jr. adds further uncertainty in assessing the prospects for meaningful legislation; however, this may be an overreaction to short-term news flow. The political environment could look quite different this fall, as Congress moves from its health care battle and onto more meaningful legislation before next year’s mid-term elections.
The impending return of fiscal stimulus and tax reform would likely provide an additional positive tailwind to smaller companies. Small-cap stocks generally have higher domestic revenue shares than their larger cap peers. This, among other tax code nuances like the interest tax deduction, translatess to relatively higher effective tax rates for small caps and lower effective tax rates for large caps. In our view, small caps may be poised to benefit from any tax reform Congress ultimately manages to muster.2
In the meantime, the threat of protectionism remains a factor, primarily threatening exporters and companies with global supply chains (most of which are large-cap companies). In addition, deregulation could potentially ease access to bank credit by making ongoing stress tests less restrictive for many banks, thereby unleashing previously sidelined capital in the process. This would not require new legislation. We believe since small-cap companies are more dependent on banks for funding, it is likely to favor small-cap stocks relative to large-cap companies.
Small-cap stocks have been outpaced by large cap stocks so far in 20173, but we see several good reasons for investors to consider exposure to small-cap equities. Past performance is not indicative of future results.
1. Source: Bloomberg. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. In this case it would be the Russell 2000 Beta vs. the S&P 500 Index.
2. Source: Our view is based on current expectations for tax reform, which resemble the various proposals announced by the Trump administration.
3. Source: Bloomberg, 7/11/2017. Please see Figure 1 for illustration.
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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Earnings-per-share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock.
Large cap (sometimes “big cap”) refers to a company with a market capitalization value of more than $5 billion. Large cap is a shortened version of the term “large market capitalization.” Market capitalization is calculated by multiplying the number of a company’s shares outstanding by its stock price per share. The dollar amounts used for the classifications “large cap,” mid cap” or “small cap” are only approximations that change over time.
Small cap is a term used to classify companies with a relatively small market capitalization. A company’s market capitalization is the market value of its outstanding shares.
The S&P 500® Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. Index results assume the reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index.
The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. The Russell 2000 is by far the most common benchmark for mutual funds that identify themselves as “small-cap.”
The Institute for Supply Management (ISM) is a non-profit organization that serves professionals, who are employed in the supply management profession. The Institute for Supply Management provides educational resources to its members, as well as creating industry standards. ISM polls its members about factors affecting their business, compiling this information in reports.
Stocks of small companies may be subject to higher price volatility, significantly lower trading volume, and greater spreads between bid and ask prices, than stocks of larger companies. Furthermore, small-cap companies may be more vulnerable to adverse business or market developments and may have more limited product lines than large-capitalization stocks
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