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Insight 30.01.2018

US tax cut: a catalyst for small cap stocks

US tax cut: a catalyst for small cap stocks

Both chambers of the US Congress are targeting a tax cut which could reach USD 1.5tn over the next decade. Much has been made of the recent US tax reform.


Both chambers of the US Congress are targeting a tax cut which could reach USD 1.5tn over the next decade. Much has been made of the recent US tax reform. Not only is it the largest reform of the US tax code in decades, but it begins to move the US from a period of monetary stimulus to one of fiscal stimulus. Reducing the corporate tax rate from 35% to 21% will be a windfall for many corporations.

One of the first consequences of this major reform is the recent weakness in the US dollar, mainly because of the prospect of lower government tax revenues and a higher deficit as a result.

The Trump administration expects that savings from a reduced tax burden will allow companies to invest strategically in their businesses. That, in turn, should lead to more job creation in the US. Our conversations with companies reveal that management teams are excited about having a level playing field, from a tax perspective, with global competitors.

There is no question in our minds that the US market has the wind in its sails. The economy is growing nicely. Business confidence is riding high, consumers are looking forward to having more money in their weekly pay packets, and inflation is still muted. That is a powerful combination.

Earnings expectations for the fourth quarter of 2017 and the first few quarters of 2018 remain solid, which should be good for stock-market returns. The speed of the US stock market’s recent gains has been impressive. While many believe this increases the risk of a pull-back, market fundamentals remain supportive of further gains.

We believe that tax reform will be good for the economy as a whole and that small-cap stocks will benefit in several ways. Most US small-cap companies are US-centric and pay a higher tax rate than their large-cap counterparts, and so tax reform will boost their earnings and cash flow.

We do not believe that small caps are fully pricing this in. If tax savings are invested wisely, they will lead to sales growth which will allow earnings to grow and stock prices to advance.

The repatriation element of the tax reform is another area of opportunity for small caps. Although large-cap companies could be the primary beneficiaries, we see the repatriation of cash as a trigger for more M&A. This should mean that small-cap stocks will become takeover targets, further supporting an optimistic outlook for those stocks. In sector terms, small caps are better positioned and thus will naturally benefit from the new tax regime. The good news is that the market has only begun to price in lower corporate tax rates.

Timing when a small cap should be added to or removed from a portfolio is intrinsically difficult. Mark Stoeckle and his team have been managing small caps for decades and they have spent a lot of time trying to determine when to get in and out of small caps, without success.

Today with the tax reform, there is a strong case for maintaining exposure to small caps or for gradually building it. Small caps have underperformed during the past five years while large caps have reached all-time highs. From the diversification point of view, adding small caps to a portfolio’s equity allocation improves its risk/return profile.

Last but not least, the small-cap universe tends to be less efficient than large caps.

With vibrant global growth, low inflation, high business confidence, strong fiscal stimulus and an attractive earnings outlook, there are many reasons to be optimistic about the US market. Given this positive environment, investors should give serious consideration to small-cap stocks.

More about US Equities

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Cédric Le Berre
Investment Specialist US & Japan

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