Small Caps And The U.S. Tax Overhaul

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Most investors anticipate that small-cap stocks have the most to gain from a tax bill overhaul since President Trump came into office, however with the bill now approaching approval, analysts have raised concerns that not all will equally benefit.

The Russell 2000 index gained almost 14 percent in the seven weeks following the 2016 election of Trump, in which a tax code renovation was central to his campaign.  In general, small caps are more sensitive to tax cuts as more revenue is generated domestically versus large caps with increased global operations.

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“Small caps underperformed for most of the year and are best able to receive the boost from a tax cut,” said Alicia Levine, Director of Portfolio Strategy at an investment management firm in New York.

The Russell 2000 index has gained 13.6 percent on the year compared to the nearly 20 percent in the S&P 500 and gain of 25 percent in the Dow Jones Industrial Average.

“There’s a misperception that broad based they’ll do well,” said Dan Hughes, vice client portfolio manager.


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As small-cap index gained just 3 percent in the two-session leading into Tuesday’s vote on the tax bill, some investors were concerned that a tax cut would only hurt certain small caps.  Some companies have yet to produce earnings and others may be susceptible to increased interest rates following the debt taken from the financial crisis.

A major concern for small caps are valuations, with the forward price-to-earnings ratio reaching at 26.1, much higher than average 21.4. That number spikes up when the companies that are included do not generate earnings.

“It’s weird to say this – but earnings matter again,” said Francis Gannon, chief investment officer.  “At a moment in time when people are looking at the index and thinking the index should benefit, the index is getting increasingly risky.”

 

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