Tax cut helping turn U.S. small caps into unlikely source of safety

  • By David Randall,
  • Reuters
  • Large-Cap Stocks
  • Investing Strategies
  • Investing in Stocks
  • Market Volatility
  • Taxes
  • Large-Cap Stocks
  • Small-Cap Stocks
  • Investing Strategies
  • Investing in Stocks
  • Market Volatility
  • Taxes
  • Large-Cap Stocks
  • Small-Cap Stocks
  • Investing Strategies
  • Investing in Stocks
  • Market Volatility
  • Taxes
  • Large-Cap Stocks
  • Small-Cap Stocks
  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print

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 (.RUT) 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).

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) and Chemical Financial Corp. (CHFC), 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), 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) 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.

  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print
© Reuters 2018. All rights reserved. Republication or redistribution of Reuters content, including by caching, framing or similar means, is expressly prohibited without the prior written consent of Reuters. Reuters and the Reuters sphere logo are registered trademarks and trademarks of the Reuters group of companies around the world.
Votes are submitted voluntarily by individuals and reflect their own opinion of the article's helpfulness. A percentage value for helpfulness will display once a sufficient number of votes have been submitted.
close
Please enter a valid e-mail address
Please enter a valid e-mail address
Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Your e-mail has been sent.
close

Your e-mail has been sent.

You May Also Like...

Peer-to-peer mobile transactions are soaring

The use of online money transfers between individuals is growing. Here's how to get started — and ways to keep your bank and personal data safe.

Taking out a loan to pay for your vacation

Companies are increasingly allowing travelers to borrow money, with the promise they'll pay later. But financial experts say there are risks.

Saving up for a down payment on a home

For renters who want to own their homes one day, the journey to build up enough savings for a down payment will be a long one. Here's why.