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March 27, 2017 | GSAM Connect

Three Things to Know About ‘Down in Cap’ Equities

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We think small- and mid-capitalization equities are well positioned for today’s market environment – here are three things we are watching in the coming months when it comes to the "down in cap" theme.

1. The Trump administration’s pro-growth, domestically-oriented agenda could benefit small- and mid-cap companies disproportionately. Smaller companies have greater exposure to the domestic economy compared to large multinationals, since they derive a larger proportion of their revenues from within the US.1 For this reason, we will be carefully watching policy initiatives aimed at stimulating the US economy.

EXHIBIT 1: SMALL STOCKS' DOMESTIC REVENUES AND TAX POLICY EXPOSURE

exhibit 1-01

Top chart source: Credit Suisse US Equity Strategy, Russell, S&P Capital IQ, Compustat. Based on FY 2015 revenues. Bottom chart source: Source: Credit Suisse US Equity Strategy, Russell, S&P Capital IQ/ClariFi, Compustat. The figures shown are the weighted medians of each index. As of 31-Dec-2016. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation. Past performance does not guarantee future results, which may vary.


Corporate tax reform is one area we are monitoring closely. The average effective tax rate of Russell 2000 Index constituents is higher (32%) than for large-cap S&P 500 companies (26%), since larger companies (which are often more global in nature) do more business in lower-tax jurisdictions. We see the potential for corporate tax cuts to exert a bigger impact on smaller companies' bottom lines than on their larger counterparts.

2. Earnings growth could accelerate, a possibility to keep in mind when evaluating valuations. Smaller-cap valuations are high versus history, but we see factors which could contribute to an inflection in earnings growth. Besides the just-mentioned potential for tax cuts, increased fiscal spending and accelerating US economic growth could each help build a positive backdrop for earings growth.

Operating margins of small companies may also have upside. They are approximately 26% below peak levels as of the end of 2016 and trail those of large-cap companies, suggesting potential for margin expansion.2

3. Smaller companies have historically outperformed in environments of rising interest rates and dollar strength. Over the last quarter century-plus, the Russell 2000 Index of small-capitalization stocks has outperformed the S&P 500 Index during periods of rising interest rates and a rising dollar. Rising rates and dollar strength have often coincided with economic expansion and earnings growth. If the current transition to a more reflationary environment takes hold, we see the potential for a positive impact on smaller companies.


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About the Author

GSAM Value Equity Team

Stable investment team that on average has over 19 years of industry experience. A team approach to decision-making that facilitates a dynamic exchange of ideas and individual accountability for investment decisions. Targeted expertise, with investment professionals focusing on specific industries to deliver depth and breadth of research.

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