Don’t you love it when the little guy wins against the giant? It goes back thousands of years to the biblical story of David, the boy who used a slingshot to defeat the Philistine giant Goliath.
The stock market may be about to do similar, with small-capitalization stocks outperforming large-cap stocks.
The reasons come down to three things: the new corporate tax rate, a reduction in regulatory burden under the Trump administration and the improving economy.
Tax cuts benefit smaller companies more. Late last year, President Donald Trump signed new tax laws that included slashing the corporate rate from 35 percent (one of the highest rates in the developed world) to 21 percent.
However, not all companies have been paying the headline 35 percent rate.
[See: 7 ETFs to Profit From Recent Tax Cuts.]
“Smaller companies pay an unfair burden of taxes relative to the larger ones,” says Jack Ablin, chief investment officer at BMO Private Bank in Chicago.
The reason for this is multifaceted. First, smaller companies don’t have the scale to employ armies of tax lawyers to legally skirt paying the headline 35 percent rate. The effective tax rate of companies in the Standard & Poor’s 500 index (the large-cap companies) averages around about 28 percent versus approximately 32 percent for small-cap companies.
Also, smaller companies are often solely domestic and so don’t have subsidiaries in low-tax countries such as Ireland.
“Going from 32 [percent] to 21 is fantastic,” Albin says. On average, after-tax profits will rise considerably more for small-cap companies than they would for large-cap ones.
Regulations rolled back. The Trump administration also slashed regulations, much to the chagrin of some, and slowed its enforcement of other regulations brought by the Obama White House.
“Despite substantial new regulatory costs finalized in the last weeks of the Obama administration, the Trump administration made significant progress in slowing this growth the remainder of the year,” states a report from the right-leaning American Action Forum. “In fact, 81 percent of all regulatory costs finalized in 2017 came during President Obama’s final weeks in office.”
Whether or not you agree with the rollback of the old rules, the question investors need to ask is how it impacts business.
Regulations are typically the same for companies regardless of their size, Ablin says. That means that they end up becoming a larger burden for smaller companies because they tend not to enjoy the same economies of scale as big companies.
[See: 10 Ways to Play the Explosive World of Small-Cap Stocks.]
There is a slight nuance to the non-enforcement of current rules. It may come back to bite some non-compliers in the future, says Robert Wright, professor of political economy at Augustana University in South Dakota. “They may end up paying later with a new regime deciding to enforce the rules,” he says.
The economy is doing well. The latest data on the U.S. economy shows it growing at an annualized rate of 3.2 percent in the three months ending in September, up from 2.8 percent 12 months earlier.
This faster rate of growth helps smaller firms proportionately more than big ones. One way to think about it is to watch how small boats get tossed around by oceans waves relative to massive ships. The smaller boats fare far worse in rough seas than battleships.
If you look at the same thing the other way around, you’ll note that when the seas are calm, then the difference between rough and fair weather means much more for the smaller vessels than it does for the bigger ones.
Similar is true of companies navigating the economy. Big, robust companies can often easily withstand economic storms, small ones less so. So, when the economic weather improves, as it has done, the smaller firms tend to see a disproportionate benefit.
How to invest. There is a lot of choice in this part of the investment market. You may want to try the iShares Russell 2000 exchange-traded fund (ticker: IWM) which tracks the Russell 2000 index of small-cap stocks. It has annual expenses of 0.2 percent, or $20 per $10,000 invested annually. Other ETFs that fill a similar role of tracking small cap stocks include Vanguard Small-Cap ( VB) and the Schwab U.S. Small-Cap ( SCHA). They have annual expenses of 0.06 and 0.05 percent respectively.
For those who want mutual funds, it might make sense to take a look at the Fidelity Small Cap Stock ( FSLCX) fund or the Conestoga Small Cap Investors ( CCASX). Both are actively managed, and both have minimum investments of $2,500. They have annual expenses of 1.02 percent and 1.1 percent, respectively.
[See: 7 Small-Cap ETFs to Buy Now.]
One caution about small-cap stocks is that the prices tend to be more volatile than larger caps, meaning the price swings of the former tend to be larger than those of the latter.
“With a long enough holding period, that exposure should pay off,” says Rebecca Kennedy, a certified financial planner and founder of Kennedy Financial Planning in Denver.
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When Are Small Companies Worth Your Investment? originally appeared on usnews.com
