Hopes of a corporate tax cut lit a fire under U.S. small-cap stocks in recent weeks, helping them to play catch-up with their large-cap counterparts.
As shown in the chart below, U.S. small caps enjoyed a performance boost after the November election on hopes of a corporate tax cut and pro-growth policies. But they failed to capture an edge on U.S. large caps until August, when prospects for tax reform regained momentum. U.S. small cap returns have outpaced those of their large-cap counterparts by more than seven percentage points since August 21. But the earnings outlook is less bright, as shown by the blue line. Analysts have been downgrading small companies’ earnings expectations throughout 2017.
In short, we believe a sustained run in U.S. small caps will require more than lower taxes.
Hurdles to clear
Small caps are seen as big beneficiaries of a corporate tax cut. The median corporate tax rate for U.S. small caps was about 33% in 2016, compared with 29% for large caps, our calculations show. Hope that a deep corporate tax cut might come to fruition helped U.S. small-cap stocks make up almost all of the year-to-date underperformance of their large-cap counterparts in just six weeks’ time.
But U.S. small caps have some hurdles to clear to win investors’ affections longer term. Strong global economic growth and a weaker dollar are boons for large multinationals, which derive more of their profits overseas. Small-cap earnings estimates also are lagging. Analysts have revised down their 2017 and 2018 estimates by 8% and 6%, respectively, year to date. This compares to downgrades of just 1% and 2% for large caps. The trend is not new. Analyst downgrades of small-cap earnings estimates have outnumbered upgrades since 2011.
Despite early-year optimism, actual earnings growth for small caps in 2017 is expected to be one-fifth that of larger companies. Disruption has played a role. Small-cap energy companies are still adapting to the shale revolution, and small consumer players are searching for an edge in a world with less brand power. One result: a profit-margin gap between large and small U.S. companies that has more than doubled since the mid-1990s. Closing this gap will require improved small-cap sales growth. Valuations leave something to be desired as well. The S&P 600 Small Cap Index is trading at a lofty 21 times forward earnings and the broader Russell 2000 Index of small-cap stocks at 27 times, even after assuming a significant tax cut-fueled earnings acceleration in the next 12 months.
Bottom line: U.S. small caps have impressed recently, but have become relatively expensive and vulnerable to any tax reform disappointment. Rather than size, we believe investors are better served focusing on equity style factors with potentially greater staying power in a sustained above-trend expansion, particularly momentum and value, as detailed in our Q4 Global Investment Outlook.
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