Protectionism and Tax Cuts Favor Small Cap

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Key Takeaways:

  • Protectionism and tax cuts could benefit small cap companies more than than multi-national large caps
  • Russell 2000 Index could be poised to reverse a multi-year trend and outperform Dow
  • Small companies with large amounts of outstanding debt could have tax cut and protectionism windfall offset by rising interest rates

The Dow Jones Industrial Average has outperformed the small cap Russell 2000 Index in three out of the last four years, and four out of the last six years. In 2017, the Dow outperformed the Russell by almost double, increasing 23% compared to the Russell 2000’s 12%.  However there is reason to believe this trend is about to change as the result of the U.S.’ economic policies, because small cap stocks should benefit even more than their large cap counterparts.

As a general rule of thumb, U.S. companies try to gain market traction in the U.S. before endeavouring to other parts of the world to look for growth. Therefore, it’s typically the larger, more mature businesses that derive a material portion of their overall revenue from countries outside of the U.S.

For this reason, when the U.S. enacts protectionist measures, the companies that often benefit the most, are those who conduct their business predominantly (if not altogether entirely) within the U.S.

The reason is two-fold. First, multi-national companies only benefit from protectionism in proportion to the amount of their business conducted in the U.S. For example, Qualcomm (QCOM) derives 3% of its business from U.S. sales, then protectionist measures will only benefit that same 3% of its business. Conversely, a defense contractor like KLX Inc. (KLXI), that derives the vast majority of its revenue from U.S. sales, will receive a much greater windfall from protectionism.

Secondly, U.S. focused companies are largely immune to any retaliatory measures that may be undertaken by trading partners, like China.

“The protectionist agenda will be better for small-caps relative to large-caps,” stated Dan Miller, director of equities at GW&K Investment Management, “I would recommend investors buy into small-caps. It’s a good time to get into those names.”

Additionally, small cap companies are alsoexpected to benefit disproportionately from the new tax cuts. Once again, multi-national organizations that generate revenue from foreign sales will only receive a tax reprieve on that portion of revenue earned in the U.S. For example, approximately 45% of Johnson and Johnson’s  (JNJ) total revenue came from U.S. sales and the company already has an effective tax rate of roughly 20%.  Compare that to a company like Meridian Bioscience (VIVO), that derives the vast majority of its revenue from U.S. sales and an effective tax rate of 40.8%.

Additionally, small businesses tend to have simple tax structures, which means their taxes are usually higher (on a percentage basis) than big companies that can afford to implement complicated, multi-layered tax plans.  In an environment where taxes are being reduced, the simplicity of a small business’ tax structure actually works in its favor, because it makes the business more sensitive tax cuts.

While small businesses are poised to benefit from protectionism and favorable tax treatment, there is still need for caution. Small businesses that are highly leveraged will be negatively impacted interest rate increases. The U.S. Federal Reserve has signalled its intent to raise interest rates several times this year. If that comes to pass, some of the benefit from protectionism and tax cuts will be mitigated for small debt-laden businesses.

For this reason we continue to believe this is a stock picker’s market. Thoughtful investments in the small cap space should out perform large cap investments, particularly those that are managed passively.

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