Orlando's Outlook: Delayed gratification for small caps

05-23-2018

Bottom line In the surprisingly heady days of November and December 2016, as investors were trying to make sense of President Trump’s shocking victory and the Republican’s stunning Congressional sweep, small-cap stocks (as measured by the RTY Russell 2000 Index) outperformed large-cap stocks (as measured by the RLG Russell 1000 Growth Index) by more than 11%. The potentially favorable fundamental underpinnings supporting small caps at that time were easy to understand, with the prospect of tax cuts, stronger economic and corporate profit growth, a tighter Fed, a stronger dollar, repatriation leading to heightened merger and acquisition activity, and the risk of trade wars and tariffs.

But after that powerful rally in late 2016, small-caps fell off the proverbial cliff for the next 14 months, as the large-cap RLG inexplicably outperformed the small-cap RTY by nearly 23% through the end of February 2018. Over the past three months, however, as the Fed’s new chair Jerome Powell hiked interest rates in March, as the U.S. economy appeared to strengthen relative to Japan and the eurozone, as the U.S. dollar finally started to catch a bid, and as investors began to worry about the economic impact from trade wars and the imposition of damaging tariffs, small-cap stocks have outperformed large caps by more than 6%. Given stronger small-cap earnings growth and relatively attractive valuations, we believe that this powerful small-cap rally has legs, as this recent reversion to the mean continues.

Stronger domestic economic and corporate profit growth We expect the U.S. economy to continue to grow at a sustainable 3% trend-line rate over the course of 2018, compared with a 2.3% GDP growth rate in the eurozone and 1.3% in Japan. More than 90% of companies have reported first-quarter corporate profits, and earnings growth for the S&P 500 exceeds 24% year-over year, marking the strongest four-quarter stretch in seven years. Quite a sharp contrast from the earnings recession we were mired in for seven quarters through mid-2016. Small-cap companies usually benefit from an acceleration of domestic economic growth, as they generate the vast majority of revenue and profits here at home. In addition, they likely would avoid most of the collateral economic damage from a global trade war, although we view that as unlikely to happen.

Tighter Fed Against this backdrop of stronger economic growth and moderately higher levels of inflation, we continue to expect the Fed to hike rates twice more in 2018 (June and December), with three quarter-point hikes to follow in 2019, which would bring the upper band of the fed funds rate to 3% by the end of next year.

Dollar catches a bid The euro outperformed the dollar by nearly 22% over the 14 months from 1.03 in early January 2017 to 1.26 in late February 2018. But given stronger domestic economic growth and a tighter central bank, that didn’t make any sense to us, as we’ve been expecting the dollar to rally against the euro back to the 1.15 level in 2018. That’s finally started to happen over the past three months, as the dollar has caught a belated bid by nearly 7% to 1.18.

The weaker dollar tends to benefit large-cap stocks, which typically export half or more of their goods and services overseas, making their products cheaper than their domestic competitors. They also benefit from the positive currency translation when they bring their profits home. But small-cap companies usually generate about 80% of their business here in the U.S., so the combination of stronger economic growth and the stronger dollar tend to benefit the small caps.

Tax cuts disproportionately benefit high-tax, small-cap companies Trump’s December tax cuts reduced the federal tax rate from 35% to 21%, which clearly had a bigger bang for the buck for small-cap companies that were generally paying taxes at or near a 40% rate. Large-cap companies, in contrast, were paying an average rate closer to 26-27%.

M&A targets Trump’s deemed repatriation tax generates nearly $400 billion in revenue for the federal government and unlocks another $2.2 trillion of cash stuck on overseas balance sheets to come home productively, to boost the economy and the financial markets. What will companies do with this money? There are many excellent choices, including increasing dividends, repurchasing shares, hiring workers, raising wages, deleveraging the balance sheet and allocating more to capex and R&D. But some companies looking for growth opportunities with new markets, products and geographies will attempt to acquire some of these innovative small-cap companies, boosting small-cap valuations.

Attractive valuation for small caps relative to large caps True, the small-cap RTY, which has broken out to an all-time high, is trading at an elevated 25.4 times consensus 2018 earnings per share (EPS) of $64.55. In contrast, the large-cap S&P 500 is trading at only 16.8 times consensus 2018 EPS of $163. But small-cap stocks are expected to enjoy a robust 3-year compound annual growth rate (CAGR) for earnings of 34% through 2020, while the comparable large-cap CAGR is at about 14%. So the price/earnings-to-growth (PEG) ratio for small caps is an attractive 0.75, compared with 1.22 for the large caps. Consequently, we believe that small-cap stocks should continue to rally, until they narrow this valuation gap over time.

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