Small Caps and Tax Reform
Tax reform is now a reality and while the implications for individuals will vary according to circumstances (consult your accountant), the 21% corporate tax rate is clearly a benefit for most companies.
One sector of the equity markets expected to see significant benefits is small-cap stocks. There are a couple of reasons for this. First, smaller companies have historically paid a higher effective tax rate, in part because they can’t shield earnings abroad in lower tax jurisdictions. The median effective tax rate for companies in the Russell 2000 Index is 31.9%, compared to 28% for companies in the S&P 500 Index, according to data from Thomson Reuters. For the 30 stocks in the Dow Jones Industrial Index, the average rate is just 23.8%.1
The potential impact of tax reform on small-cap stocks could be seen in the reaction of the asset class to the ebbs and flows of the tax bill. Thomson Reuters noted that the Russell 2000 Index was up nearly 14% between Election Day and the end of 2016, but the rally stalled out, as the prospects for tax reform became more uncertain.
A second consideration: most small-cap companies are domestically focused. The average company in the Russell 2000 Index generates about 20% of its revenue from outside the U.S.2 For the S&P 500 Index, that number was more than 40% in 2016. That means that a greater part of these small-cap companies’ revenues and earnings will be taxed at the new, lower 21% level.3
Finally, small caps have the potential to benefit from faster economic growth generally (assuming it materializes). Some of this may already be built into the market: the S&P 500 Index recently traded at a forward P/E ratio of slightly more than 18; for the S&P Small Cap 600 Index, the comparable figure was just over 20. Still, this may be justified if small-cap earnings do, in fact, benefit disproportionately from both tax reform and a broader growth environment. Other potential positives: M&A, with small caps being taken out at a premium by larger companies looking to buy growth or access to innovative products and services, and ironically, the opportunity for domestically focused companies to expand into more rapidly growing economies abroad.4
One negative might be the cost of capital – small-cap companies generally pay more to borrow, and a stronger, post-tax reform economy might mean higher interest rates. On the flip side, many of these companies are not active in the debt markets. Small caps do tend to be more volatile, and not every small company is destined to become a big one. In this asset class in particular, having a well-diversified portfolio is important.
1. Fox, Michelle, ‘These stocks will benefit the most from tax reform: Goldman Sachs’ CNBC, September 28, 2017.
2. Park, JeeYeon, ‘Worried about world economy? Bet on US small caps: Goldman’ CNBC, April 29, 2013.
3. Cision, PR Newswire, ‘S&P 500 foreign sales decline to 43.2%, at lowest level since 2003,’ S&P Dow Jones Indices, July 20, 2017
4. Yardeni Research, Inc., ‘Stock Market Briefing: Selected P/E Ratios. January 3, 2018.
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S&P 500 is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion.
Russell 2000 is an index measuring the performance approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States.
Dow Jones Industrial Index is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ.
Forward P/E ratio is a measure of the price-to-earnings (P/E) ratio using forecasted earnings for the P/E calculation. While the earnings used are just an estimate and are not as reliable as current earnings data, there is still benefit in estimated P/E analysis.
S&P 600 Small Cap Index is an index of small-cap stocks managed by Standard and Poor’s. It tracks a broad range of small-sized companies that meet specific liquidity and stability requirements.
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