Strong Small-Cap Equity Market Attractive to Investors
June 28, 2018
Facing the prospect of an escalating trade war and increasing U.S. dollar volatility, more investors are looking to hedge risk by turning to smaller domestic public companies that offer a measure of protection from international fluctuations.
So far in 2018, small-cap stocks have offered strong returns without much corresponding volatility, outperforming large-cap firms by a considerable margin in both regards. The small-cap universe has easily outpaced the 3 percent increase in the S&P 500 as of June 27.
CNBC, citing FactSet data, reported that investors in exchange-traded funds have recently turned away from large caps, pulling some $20 billion out of two major large-cap stock index ETFs in March alone. The iShares Russell 2000 ETF added over $2 billion over the same period.
Although the recent equity market pull back has been hard on small cap companies, the trend toward outperformance may continue through the year. Investors looking to avoid exposure to increasingly volatile foreign markets could retreat from some overseas companies and gravitate toward small-cap companies, which tend to operate largely in the U.S. Here’s a closer look at some of those dynamics driving investors to small caps.
Protections from Trade Wars
American tariffs on steel and aluminum have driven investors away from large-cap companies with significant overseas markets, whose revenue and profits are likely to be more heavily impacted by a trade war with China or other nations. U.S. small-cap stocks, however, typically generate most of their revenue domestically and tend to be more immune to international trade policy disputes.
In a recent note, analysts encouraged investors continue to overweight small-cap stocks. “We continue to recommend small-caps as a ‘catch-all trade’ for its high cyclical, reflation and tax policy exposures, as well as lower sensitivity to ongoing trade risk,” equity strategist Dubravko Lakos-Bujas wrote in the note, reported by CNBC.
The Rising Dollar
The continuing rise of the U.S. dollar is impacting domestic equities, but most smaller U.S. companies are again more insulated from the impacts of a rising dollar because the majority of their sales come from domestic markets. Larger firms, on the other hand, tend to have significant international operations, which are typically negatively impacted by a rising U.S. dollar.
Companies that make up the S&P SmallCap 600 drive 78.8 percent of their revenue from the U.S., compared with 73.3 percent in the S&P MidCap 400 and the 70.9 percent in the S&P 500. Historically, that has played out with small-cap stocks weathering geopolitical turmoil and currency fluctuations more effectively than large-cap equities.
Jodie Gunzberg, managing director and head of U.S. equities at New York-based S&P Dow Jones Indices, told U.S. News & World Report that over the past decade, for every 1 percent the dollar has risen, small caps gained 95 basis points, compared with a mid-cap jump of 82 basis points and large-cap increase of 71 basis points.
Strong Revenue Outlook
There is analyst consensus around the notion that U.S. small and mid-sized public companies are better positioned for a boost from the corporate tax cuts than are most large firms that make up the S&P 500.
Companies in the Russell 2000 have paid at least $9.2 billion less in taxes in the second quarter compared with the last quarter of 2017, according to some estimates, reported by Reuters. Smaller firms have shown a propensity to reinvest those savings over buybacks, in contrast to larger firms.
Small cap stocks should likely be a component of a strategic asset allocation in most market cycles, but is definitely worth evaluating in the current environment, which seems favorable.
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