Small is Beautiful

U.S. smaller companies have endured seven lean years, but are they poised for a comeback?

The influential German economist E.F. Schumacher coined the phrase “small is beautiful” back in 1973 in his best-selling book about the relation between mankind and technology. A protégé of John Maynard Keynes, Schumacher explored the link between economics and natural resources. Today, however, I’d like to appropriate his phrase to describe the sweet spot many U.S. small companies currently find themselves in.

The U.S. economy is thriving. Consumer spending, new housing, employment numbers and Purchasing Managers’ Index data are all rising at the same time that consumer and business-leader confidence are hitting secular highs. In addition, despite the disappointment in some quarters at the new administration’s failure to repeal and replace Obamacare, there is still an expectation that its plans to reduce regulation, reform taxation and increase infrastructure spending will give the U.S. economy a boost. As we seek to identify those areas that most likely stand to benefit from current growth and these future initiatives, U.S. smaller companies loom large on our radar.

Here’s why.

U.S. smaller companies are more geared to the local economy than their larger cousins and generate a much smaller proportion of their sales from overseas. As a result, they are better positioned to benefit from the positive economic environment in the U.S. They have also borne a disproportionate cost of increasing regulatory burdens over the last number of years—any reduction in this burden will likely have an outsized impact on their earnings. Smaller companies also tend to pay higher taxes than larger companies because they don’t have the benefit of operating in international tax jurisdictions. As a result, smaller companies are more likely to benefit from tax reform. Finally, given their U.S.-centric business models, smaller companies are likely to be less concerned about the potentially negative impact of a rising dollar.

Noise annoys
In previous CIO Weeklies, I’ve talked about the importance of distinguishing between noise and signals. Today, that distinction is more important than ever. By looking beyond the headlines, investors can uncover opportunities that reflect a combination of positive cyclical trends and longer-term drivers. Smaller companies are a prime example of this.

Historically, small cap companies have often provided a good risk premium over larger capitalized stocks. However, it’s a very cyclical asset class and in recent years small caps have underperformed. Indeed, the Russell 2000 Index has underperformed the S&P 500 over recent time periods. But after a healthy bounce in 2016, many believe that the strong relative performance from smaller companies can continue. Smaller company valuations and earnings are not currently as stretched as larger company stocks. In fact, as the S&P 500 has continued to soar this year (+6.31% to March 30) the small company Russell 2000 Index is only up 1.75%, also to March 30. Yet, as described above, this segment is a likely beneficiary of both cyclical economic growth and policy changes.

An important consideration for investors in U.S. small company stocks is the diversity and potential inefficiency of the universe. It’s a less well-researched area than large company names, with the potential for divergences between stock prices and company fundamentals. Also, while many small companies have sound business models, which stand to benefit from the dynamics described above, a meaningful component of the universe are the money-losing companies who have been able to stay in business due to low interest rates. As policy rates normalize in the coming years, there will likely be distinct winners and losers.

Finally, small companies can be very attractive M&A targets. Indeed, if robust M&A activity continues, this can be an additional driver of smaller company relative performance since they are much more likely to be targets than larger companies. As a result of all these factors, small company stock investing may lend itself more to active approaches to portfolio management, seeking both to enhance return potential and manage the risks of investing in what can be a more volatile market component.

Changing focus
The current environment can seem baffling, with investors grappling to make sense of the latest political developments while also dealing with the quotidian demands of running their investment portfolios. Yet those who can zone out the noise and focus on the fundamentals are beginning to identify new opportunities in unloved sectors of the market such as U.S. small caps. In the post-GFC environment, where central banks drove the recovery pursuing non-traditional monetary policies, large companies benefited. As we enter a new stage of the business cycle, where economic growth and interest rates normalize, and fiscal policy dominates, we believe it may be an opportune time to focus further down the capitalization spectrum. In short, we believe smaller companies are long overdue a rebound. Small can indeed be beautiful.

Erik L. Knutzen, CFA, CAIA – Portfolio Manager – Neuberger Bergman