Market Memo: Small caps may have more room to run

03-30-2017

Last year, the small-cap asset class delivered a strong showing, with the Russell 2000 Index returning 21.3%. Now that 2017 is well underway, can the small-cap advance continue? Federated MDT strategists believe current support for the asset class remains solid and that the better question isn’t whether to invest in small caps, but how.

Small caps are still timely
Among the Trump administration’s priorities are proposed policies that are positive for small caps:

  • Tax reduction Large corporations have been able to take advantage of tax loop holes, so their effective tax rate is already lower than that of their small-cap counterparts. Therefore, if the playing field is leveled to a lower statutory corporate tax rate, perhaps from 35% to 25% for all companies, small caps will get a greater boost to net earnings.
  • Tax repatriation President Trump is proposing a “tax holiday” that could allow approximately $1 trillion in overseas corporate cash to return to the U.S., with a sizeable portion of that cash likely to be used for acquisitions in addition to share repurchases and capital expenditures. Again, small caps benefit since they represent approximately 90% of all acquisitions, according to Strategas Research.
  • Regulatory reform Trump is promising to apply a one-for-two rule; that is, axing two regulations for every new regulation. It is widely understood that small businesses bear the brunt of regulatory costs, so any relief will be more beneficial to smaller companies.
  • Infrastructure The government wants to spend $1 trillion over a decade on infrastructure. Improvements made to U.S. bridges, roads and airports primarily will be done at the local level. Large industrial companies that supply machinery as well as large materials companies supplying steel and concrete are obvious beneficiaries. But many small companies, including engineering and construction firms as well as restaurants, hotels and related businesses across the supply chain, stand to gain.

If these policies are successfully implemented, the U.S. economy should accelerate, resulting in higher inflation, rising interest rates and a strengthening U.S. dollar. Because of the domestic bias of small caps (just 21% of small-cap revenues are generated abroad), they are well insulated from a rising dollar. Likewise, should a Trump-inspired trade war ensue, large global companies will likely be significantly more challenged than small companies that generate more of their sales domestically.

Another period remarkably akin to the current environment for small caps was from 1980 to 1983. During that time, President Ronald Reagan was just taking office and immediately the market began pricing in policies similar to those proposed by Trump, specifically fewer regulations and lower taxes. In 1980, small caps as measured by the Russell 2000 Index returned 38.6%, outpacing large caps as measured by the Russell 1000 Index by close to 700 basis points. The rally continued through 1983. During this 4-year stretch, small caps posted a cumulative return of 128%, outperforming large caps by 44%.

Small caps are timeless
Small caps, while more volatile, have produced greater returns than large caps over time. Over the last 15 years, small caps have outperformed large caps by more than 125 basis points per year; cumulatively, small caps provided a 59% return differential over the last 15 years, according to the respective Russell indexes (see chart below).

Indexes

Total Return, annualized

3/1/2002 - 2/28/2017

Total Return, cumulative

3/1/2002-2/28/2017

Russell 2000 8.93% 260.85%
Russell 1000 7.65% 201.96%

Index performance is for illustrative purposes only and not representative of performance for any specific investment.

Small cap’s potential active management advantage
Small cap stocks are far greater in number and far less followed by the analyst community. As a result, there are likely to be more mispriced securities in the inefficient small-cap universe, which may bode well for skilled active managers.

Consider the rolling 36-month performance going back seven years (Jan. 1, 2010-Dec. 31, 2016) for all active small- and large-core U.S. institutional class mutual funds. The average percentage of time a manager was able to beat the benchmark was 53% for small-cap managers versus 26% for large-cap managers based on the aforementioned Russell indexes, according to Morningstar. Importantly, the environment for active may be even more favorable given the probability of winners and losers stemming from the Trump administration’s policies. It’s the job of investment managers to discover those under-the-radar companies that have the managements, business models, competitive advantages and fundamentals to ride out market, economic and these policy-based fluctuations.