The
Republican-led corporate tax cut is helping turn the shares of smaller
publicly-traded companies in the United States into an unexpected source of
stability as the broader stock market wobbles.
Typically, the
shares of small and mid cap companies in the Russell 2000 index are more
volatile than the large cap S&P 500 .SPX, in
part due to their concentration on the U.S. economy and smaller financial
cushions.
Yet since
concerns about rising inflation and an escalating trade war stopped the broad
U.S. stock market in its tracks after the S&P 500 hit record highs in
January, the Russell 2000 has held on to more of its gains. It dropped 0.4
percent from its high of the year, compared with a 5.5 percent decline in the
S&P 500.
“When you look
at the remainder of 2018 and especially going into 2019, the forward expectations
are that the small cap universe is going to see accelerating earnings growth,
whereas the large caps in general are still going to be growing but they won’t
see a benefit as magnified,” said Martin Jarzebowski, a portfolio manager at
the Federated Clover Small Cap Value fund (VSFAX.O).
Fund managers
and analysts say that small companies are benefiting in part from December’s
tax cut, which slashed the average tax rate among small cap companies from 35
percent to 21 percent.
Large cap
companies, which earn a greater percentage of their revenues abroad, saw their
effective tax rates fall from roughly 27.5 percent to 22.5 percent, according
to estimates from Credit Suisse.
So far,
companies in the Russell 2000 have paid $9.2 billion less in taxes this quarter
compared with the last quarter of 2017, before the tax bill passed, according
to estimates from Sandy Villere, a fund manager at New Orleans-based Villere
Funds.
Jarzebowski
said he has been focusing more of his portfolio on small cap financial
companies seeing the greatest benefit from lower taxes and low unemployment,
such as First Midwest Bancorp Inc (FMBI.O)
and Chemical Financial Corp (CHFC.O),
both of which are up approximately 3 percent for the year to date.
Small companies
are also improving their margins by an average of 0.5 percent as they spend
less on buybacks and more on reinvesting, said Venu Krishna, a strategist at
Barclays. That, in turn, should provide a cushion for small caps even if wider
volatility continues, he said.
“You are going
to see more respectable earnings throughout the year, even after the benefits
of the tax cut are factored away,” he said.
The volatility
has shrunk trailing price-to-earnings valuations by 6 percent since the Russell
2000 hit a record high in January, Krishna added, leaving small caps both
cheaper and less risky at a time when companies are growing their pre-tax
earnings by an average of 14 percent year-on-year.
Eric Marshall,
a fund manager at Dallas-based Hodges Capital, is moving more of his portfolio
into small cap retail companies that are trading at depressed multiples. The
retail sector is expected to see a significant benefit from the tax cut because
the majority of revenues are domestic.
“For the most
part the tax cuts are already factored in by the market and if you see a
company beat estimates by just a penny or two they’re not getting rewarded for
that,” he said. “We’re looking for areas where there’s top-line growth and
increased consumption in places you haven’t seen that for a while.”
Portfolio
holding American Eagle Outfitters Inc (AEO.N),
for instance, recently hit a five-year high, thanks in large part to the growth
of its Aerie lingerie brand that is taking market share away from L Brands’ (LB.N)
Victoria’s Secret.
“You had the
market pretty much leaving retail for dead, and that’s one place where we are
seeing a lot of value,” Marshall said.
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