logo-loader

Here's why US small-caps are flying high in the face of inflation and risk

Published: 05:00 26 May 2018 AEST

Big dollar sign against cityscape
Could President Trump's tax reforms act as a buffer against a future pullback?

Shares of small-cap companies are climbing to new peaks, showcasing the sizzling potential of companies with market caps of less than $2bn.

The Russell 2000 and the S&P 600 are both marching higher, having reached new all-time highs in recent weeks, with the Russell 2000 now trading above 1,623 and the S&P 600 breaking through the key psychological barrier of 1,000.

Over the past 52 weeks, the Russell 2000 is up 18% and the S&P 600 as much as 20% against a 13% rise in the benchmark S&P 500.

And over the course of the last two years, the small-caps’ lead is even more pronounced as the Russell 2000 and the S&P 600 have both jumped 47% compared with a 32% rise by the S&P 500 and a 41% rise from the Dow Jones Industrial Average index.

“There is something special about the way the small-cap market is rallying,” said Tarun Chandra, an investment analyst with the advisory firm Graycell Advisors.

The outperformance of small caps against their more prominent large-cap counterparts since the year’s start suggests that small caps – which tend to boast revenues focused on the domestic economy – can be a shrewd choice when markets are thrown off by broader economic and political concerns of an international nature.

Domestic bliss

With President Trump’s abrupt move to cancel the North Korean summit and the threats of a trade war with China, US tariffs on foreign automobiles as well as rising inflation, small-caps are coming into vogue as they seem far less exposed to the world’s problems.

“With all the talk of trade wars and tariffs, small-caps look particularly appealing since they are largely domestic plays,” says Craig Hodges, chief executive officer and a small-cap portfolio manager at Hodges Mutual Funds

Hodges also points out that small-caps are the chief beneficiaries of the recent changes to the US tax code and the decrease seen recently in regulation. He forecasts that a wave of mergers and acquisitions is also likely to benefit smaller companies as large companies look for ways to spend their cash piles.

“Instead of buying back stocks, large-caps will move into mergers and acquisitions as well and that will boost small-caps,” Hodges says.

Chandra, a well-known financial writer, stresses that there’s something democratic about the dramatic rise of the small-caps.

“As investors have become accustomed to a market being consistently led by a group of mega-caps like Amazon, Alphabet, Facebook, Apple, Netflix, Nvidia and Microsoft, the small-cap rally being witnessed this month is a pleasant departure and provides a more democratic tenor to the bull market,” Chandra wrote in a recent investment newsletter.

Buyer beware

Another reason behind the growing popularity of small-caps is that there are simply fewer listed equities to buy into. Twenty years ago, there were as many as 7,800 listed companies and that number has been more than halved to about 3,500, by Hodges’ estimates.

“A lot of stock has been retired. There have been a lot of buyouts and a lot of big companies are staying private. So, there’s a lot less stock to go around,” Hodges says.

The strengthening US dollar is also playing well for smaller companies. This is because they are not particularly exposed to the threats and counterthreats of the ongoing tariff wars being staged now.

Higher volatility, diminished liquidity and a dearth of research,  however, are among the risks when investing in small-caps, fund managers warn.

“The nature of small-cap stocks lends itself to poorer overall quality, which requires a discerning view to avoid value traps,” wrote Ehren Stanhope and Chris Meredith, investment analysts with O’Shaughnessy Asset Management in a note. “Liquidity is an important consideration because it can erode excess returns in real-world application.”

The small-cap space also still suffers from a dearth of research analysts digging into it. “Because of the popularity of passive investing, less and less people are doing bottom-up research into small-cap stocks,” says Hodges.

But Chandra points out that small-caps are a barometer for investors’ appetite for risk-taking. The new highs suggest that investors remain willing to take less conventional bets, even though they still appear to be harboring reservations about volatility and rising interest rates.

A changing climate

Looking to history as a guide, it could well be the case that any surge in the small-cap arena is accompanied by sluggish economic growth.

From 1979 to 2015, annual gross domestic product growth fell below 3% about half of the time, according to research provided by the FTSE Russell, the UK index provider. In those years of lackluster GDP growth, small-caps tended to outperform large-caps. Most notably, small-caps did better than large-caps in two of the three years in which GDP growth was negative during those years.

Times change, however. Seth R Freeman, a senior managing director with GlassRatner Advisory & Capital Group LLC, said he doesn’t think this historical trend is always the norm. He sees more of a symbiotic relationship between large-caps and small-caps as a number of small-cap companies act as vendors and service providers to large-cap ones and tend to profit in periods of largesse and struggle when large companies' fortunes diminish.

“They can be a little more nimble than large-cap ones and they can be more entrepreneurial,” he said. “But a lot of small-cap companies are vendors and service providers to large-cap companies.”

In an economy that is beginning to inflate and where interest rates are poised to rise, small-cap companies in the US will have fewer financing options than they once had, according to Freeman. But they will be saved by the recent tax law changes, which permit them to deduct their capital investments.

“The tax code changes are good for small-caps,” concludes Freeman. “In my view, the new tax laws are going to constrain a cyclical recession.”

Poseidon Nickel signs binding agreement with Mineral Resources to divest...

Departing Poseidon Nickel Ltd (ASX:POS, OTC:PSDNF) CEO Craig Jones and incoming CEO Brendan Shalders join Proactive’s Jonathan Jackson to discuss the divestment of Lake Johnston to Mineral Resources Ltd (ASX:MIN). Jones, who has played a pivotal role in this strategic move, shared insights on...

2 hours, 10 minutes ago