Recently passed tax-code changes possibly favoring small companies may finally allow small-cap investments to live up to their historical tendency to outperform large caps.
Small-cap exchange-traded funds can use the help. Small caps underperformed large caps in 2017, as the iShares Russell 2000 ETF (IWM) returned 14.59 percent versus 21.70 percent for the SPDR S&P 500 ETF Trust (SPY). It has been tough sledding for small caps relative to large caps in recent years, as IWM underperformed SPY in three-year and five-year returns, too. That said, IWM has outperformed in the 10-year and 15-year timeframes.
Tax-code changes should help small caps, but market watchers say other factors could have just as much influence. High valuations, along with possible tightening credit conditions if interest rates rise, may hamper these companies.
Under the tax-code changes, small caps are likely to have a better earnings outlook and higher potential for margin expansion versus large caps, says Morgan Stanley. The bank says small-cap incremental operating margins never recovered after the 2008 financial crisis while operating margins at large-cap companies did.
“Large caps had the size/scale to cut costs more effectively than small caps. Furthermore, large caps had access to cheaper debt financing, enabling them to fund operations more freely and drive operating margins. As the QE (quantitative easing) era ends, the dynamic may begin to shift and small caps should be able to operate on more of a level playing field,” Morgan Stanley says.
Sal Bruno, chief investment officer with IndexIQ, says small caps will likely disproportionally benefit from the tax-code changes since they were paying a higher effective rate than large caps. He adds that the research IndexIQ has done, along with data from FactSet and Bloomberg, showed that prior to the tax changes large-cap companies paid an effective rate of 28 percent versus 33 percent for small caps.
There also might be a pickup in merger and acquisition activity with the new tax code, Bruno says, and usually smaller companies are targets.
Small companies could benefit from tax changes, but Jim Paulsen, chief investment strategist at the Leuthold Group, says investors may need to rethink their assumptions.
“I think there are too high of expectations about the advantage coming from tax reform," he says. "It may be true that small companies [may benefit], but not necessarily small-company stocks.”
Aside from the tax-code changes, Morgan Stanley says the current economic cycle as a whole will drive equities. Their bias is toward cyclical investments, flagging late-economic cycle sectors like industrials and energy to be market leaders. “The global economic and growth story that began in 2016 has been the primary underlying narrative in the market,” the bank says.