Small caps and trade wars
Trade wars tend to hit companies in two major ways: 1) with tariffs that impact products, services, and sectors, and 2) through currency relationships, which are often upended as part of the dispute.
Some companies do better than others. In the current contretemps, multinationals with significant non-dollar revenues and companies with direct exposure to products or materials subject to tariffs are likely to see the biggest negative impact. On the other hand, companies doing business all or mostly in the U.S., and that either source their materials domestically or whose materials are not subject to the tariffs, should manage to sidestep much of the damage. This rule of thumb would apply to companies of any size, but it most broadly describes small caps.
You can see the impact in the numbers. S&P 500 companies get about 38% of their income from outside the U.S. The figure for S&P Small Cap 600 is only 20%, both according to FactSet.1 For the Russell 2000, less than 20% of sales come from non-US markets. Partly as a result, the S&P Small Cap 600 was up 12.4% year-to-date through early June and was hitting record highs, while the Russell 2000 climbed 11.2%, according to data cited in The Wall Street Journal. This compared with a 3.5% gain for the S&P 500.2
Clearly small caps have been on a tear this year, so investors and advisors looking at the asset class may want to pay particular attention to valuations and, for ETFs, the methodology used by the underlying index to select stocks. Important measures to consider include price-to-book, price-to-sales, price/earnings, and price-to-cash flow. Sentiment is important, too, as it can provide an extra layer of insight into future returns and includes factors like insider buying and short sales volume. These considerations can help avoid investing in high-priced stocks with less than stellar earning prospects. Steering clear of mistakes can be a significant contributor to returns.
Other reasons to own small caps
Sidestepping the impact of a trade war isn’t the only reason to invest in small caps. Periods of deregulation like we’re currently experiencing have historically favored this asset class, as smaller companies can be disproportionately impacted by lower compliance costs. We’re seeing record levels of M&A and while a lot of that has been focused on large caps, it’s likely to migrate down at some point as companies continue to look to acquisitions to enter new markets, get access to new technology, and accelerate growth. Finally, there’s earnings, the ultimate arbiter of value. Small cap earnings have historically grown faster than those of large caps, and that provides support for both valuations and long-term price appreciation.
When it comes to trade wars, economists generally believe that no one ultimately wins as tariffs can cause price distortions and a misallocation of capital, among other corollary damage. Some companies have been specifically hurt by the kind of targeted tariffs that have been put in place so far, and by the retaliation that has followed. Other companies and asset classes are better positioned to succeed in these circumstances. In that regard, domestically focused small caps and small cap ETFs are worth a look.
1. FactSet, as of June 30, 2018.
2. The Wall Street Journal, “Small-Cap Stocks: Where Investors Hide in a Trade War,” wsj.com, June 21, 2018.
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Small and mid-cap stocks are often more volatile than large-cap stocks. Smaller companies generally face higher risks due to their limited product lines, markets and financial markets.
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.
Russell 2000 Index is an index measuring the performance of 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.
S&P 500, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value and is one of the most common benchmarks for the broader U.S. equity markets.
S&P Small Cap 600 Index measures the small-cap segment of the U.S. equity market. The index is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable.
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