Two Macroeconomic Factors Impacting Small Caps

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Key Takeaways

  • This earnings season, ignore earnings growth and focus on revenue and gross margins
  • If Dodd-Frank amendments pass, regional banks will not benefit equally

We’re just on the other side of earnings season, and there were a number of significant beats. One of the primary growth catalysts for the market were the tax cuts passed late last year. This was the first time that the tax stimulus is impacted bottom lines. A number of companies posted impressive earnings, including: Amazon, Facebook, McDonalds and Google.

The tax cut benefits aren’t limited to large companies. Some analysts predict that the Russell 2000 could see a boost to earnings per share of almost 10%,  this year. That figure even outpaces the anticipated increase to large cap earnings, which is estimated to be around 7%.

For the foreseeable future, the tax cuts will continue to drive earnings, but they are a synthetic catalyst. In other words, a company’s actual business could slow, but their earnings might still increase as the result of the tax stimulus. For that reason, we’re placing far less emphasis on earnings for the next few quarters, and watching other metrics that we believe will more indicative of performance, namely revenue and gross margins.

Tax Cuts

This strategy is especially true for small cap stocks, because most small caps derive the majority of their revenue from domestic sales, which means they stand to benefit the most from tax incentives.

For instance, the energy sector is expected to benefit heavily from the tax cuts, so we’re watching companies like Wildhorse Resource Development Corporation (WRD), Delek US Holdings (DK)  CVR Refining, LP (CVRR) is another company we like in the energy space, and they reported a monster first quarter, as the company’s EBITDA grew 80% to $760 million.

Dodd-Frank Revisions

Some regional banks also stand to benefit from the proposed roll-back of the Dodd-Frank banking regulations. Dodd-Frank was ratified in 2010, in response to the financial crisis of 2008. The bill enacted strict banking regulations, which sought to constrain everything from deposit and reserve levels to trading. It is widely believed that the Dodd-Frank regulations are a large part of the reason that present day banks are generally in such strong financial condition.

Though Dodd-Frank was ostensibly aimed at regulating institutions that were “too big to fail”, smaller banks were also subject to the increased regulation. The proposed revision of Dodd-Frank would undoubtedly be a tremendous growth driver for large banks, however the benefit to small regional banks may be less defined.

The proposed roll-back exempts banks from rules on mortgage lending, trading, and regulatory exams. On the surface, these exemptions seem like they would help small banks by allowing them by easing the regulatory burden, it doesn’t do much for smaller banks because the roll backs don’t apply to their primary businesses.  In other words, they would still be forced to comply with the most onerous parts of Dodd-Frank.

If the Dodd-Frank repeal were to pass, the primary beneficiaries would be larger regional banks with assets of $50 billion to $250 billion.  With that in mind, we’re keeping an eye on Sun Trust Banks (STI) and Ally Financial (ALLY). Both of these banks would benefit disproportionately from the proposed Dodd-Frank rollback. We may end up adding them to the Sylva portfolio if we believe the repeal will pass.

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