U.S. small and mid-sized public companies are positioned to profit from the corporate tax cuts more than the large corporations represented in the S&P 500.
Small and mid-sized companies may receive a greater benefit from the recent corporate tax reform compared to large companies who pay upwards of 40 percent of their taxes overseas, says Jon Ulin, a managing principal of Ulin & Co. Wealth Management in Boca Raton, Florida. The significant increase in free cash flow from many of these smaller companies will help directly fuel growth, wages and jobs in the U.S.
“While following the Gretzky maxim to ‘skate to where the puck is going, not where it has been,’ small and mid-cap stock sectors appear to be poised for greater growth in 2018 and 2019 compared to the S&P 500,” he says.
Small and mid-cap indices are up 8 percent and 5 percent year-to-date, while the Dow Jones industrial average is only up 1 percent. The small-cap growth stocks and mid-cap growth stocks are up 15 percent and 12 percent respectively, according to data from Morningstar.
[See: 7 Small-Cap Stocks with Big Dividends.]
Small-cap stocks outperform when the dollar rises. The largest reason small and mid-cap stocks are outperforming their larger peers is the strengthening U.S. dollar, says David Twibell, president of Englewood, Colo.-based Custom Portfolio Group.
Most smaller U.S. companies are more insulated from a rising dollar since the bulk of their sales come from domestic markets while larger companies have significant international operations, which are negatively impacted by a rising U.S. dollar.
“The recent surge in the dollar’s value relative to most other currencies means these companies are likely to have some sizable headwinds to future international sales growth,” he says.
Small-cap stocks tend to outperform mid-cap and large-cap stocks when the dollar is rising because the majority of their revenue is derived from the U.S. The S&P SmallCap 600 has 78.8 percent of its revenues derived from the U.S., while the S&P MidCap 400 has 73.3 percent and the S&P 500 has the lowest percentage at 70.9 percent.
“A potentially higher U.S. dollar and corporate tax reform are both solid reasons we like small caps moving forward,” Ulin says. “The U.S. dollar should continue to strengthen over the next year powered by the tailwinds of rising interest rates, weak economic data overseas and a repatriation of overseas cash. Typically, when the U.S. dollar rises, small caps tend to outpace large caps.”
Investors may want to increase small-cap exposure. With the increased volatility in the stock market, investors who have a large percentage of their retirement portfolio allocated toward large-cap stocks should consider mixing in small and mid-caps.
“It may make sense for investors to add small and mid-cap stocks to their portfolio, particularly if they don’t have much exposure currently,” Twibell says. “The combination of tax cuts, domestic economic growth and a rising U.S. dollar are all tailwinds to potential outperformance for these stocks versus their larger-cap counterparts.”
[See: 7 Best Mid-Cap Stocks to Buy Now.]
Investors should remember that the impact of the tax cuts is likely already factored into the markets, he says.
“The trajectory of both domestic economic growth and the U.S. dollar could easily change in coming months,” Twibell says.
As both GDP and corporate earnings have risen due to the strengthening U.S. economy, the advancing of the U.S. dollar index is also providing tailwinds in 2018 for small and mid-cap stocks, reversing the trend of the declining dollar.
“Based on these positive technical and fundamental factors, we have modestly increased our exposure to U.S. small and mid-cap stocks in our diversified portfolios and reduced exposure to large caps,” Ulin says.
Use mutual funds and ETFs for small-cap exposure. Adding small-cap and mid-cap stocks to a portfolio can be advantageous if the investor lacks exposure to them and has too high of a concentration in large stocks, says Robert Johnson, principal at the Fed Policy Investment Research Group in Charlottesville, Virginia.
“The preferred method of gaining that exposure is through mutual funds and ETFs because individual small and mid-cap stocks can be quite volatile,” he says.
While smaller companies tend to benefit more from tax cuts, they are also more negatively affected by a rising interest rate environment.
“Small firms are more sensitive to monetary conditions because they generally have less access to sources of capital,” Johnson says. “In tighter monetary conditions, smaller firms have more trouble acquiring funds through bank loans and issuing bonds than do large firms.”
[See: 7 Small-Cap ETFs to Help You Win a Trade War.]
Although interest rates remain historically low, the Federal Reserve has stated it intends to continue to raise rates.
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Small and Mid-Cap Stocks Benefit from Tax Cut originally appeared on usnews.com
