In Short: Small caps might be today's Goldilocks investment

07-03-2018

At a time when domestic economic and earnings strength is counterbalanced with concerns over global trade and tariff volatility, small-cap stocks offer some important advantages. When it comes to trade issues, consider that U.S. small companies conduct about 80% of their business domestically. As a result, their stocks are much more insulated from global trade conflicts than their large-cap peers, which tend to conduct half or more of their business overseas.  

Also favoring small caps: a strengthening U.S. dollar resulting from the combination of stronger domestic economic growth and rising interest rates. With their significantly greater exposure to global markets, large corporations lose a competitive advantage when a strong dollar makes their goods and services less attractive. Domestically focused small companies tend to be immune to a rising dollar.

Finally, merger and acquisition activity is on an upswing, responding to the new tax law that makes repatriation of foreign-held cash cheaper. A portion of that returning $2.6 trillion is being used by corporations to buy small companies, particularly tech and biotech firms. It’s the shares of those small-cap acquisition targets that experience the greatest upside.

Over the past five months, the Russell 2000 Index, a barometer for U.S. small-cap performance, has hit a series of new highs and is up more than 19%. Although small caps have experienced a recent and expected pullback of about 5%, we believe it is overdone and, in our view, represents an attractive buying opportunity.