Small & Mid-Cap Equities: Smaller companies in a changing world
Daniel Ben-Ami looks at how smaller companies are adapting to the economic and political landscape
At a glance
• The shift in the economic and political climate could benefit smaller companies relative to larger ones.
• US small caps benefited from the expectation of tax cuts by the incoming Trump administration.
• A fiscal stimulus in the euro-zone looks unlikely at least until the elections later in the year.
• Small caps are usually favoured in the earlier stages of the economic growth cycle.
How are small and medium-sized companies likely to fare in the changing political and economic climate? The world seems to be becoming more national and less global with growing calls for protectionism in trade and tighter curbs on migration. If such demands are realised, the new environment might be expected to benefit small and mid caps relative to large ones.
Since small caps are generally more domestically oriented than large ones, they might be expected to do better than large ones in a less global world. Mid caps, as might be expected, are some way between the two on the spectrum.
Matthew Dobbs, the head of global small caps at Schroders, argues that there are additional reasons why certain smaller companies could benefit from such a shake-up. “The larger companies tend to know the rules of the game,” he says. “They are embedded in the establishment.
“But when that starts getting shaken up I think it can give real opportunities for entrepreneurial companies that are sitting in little niches that they can then grow because something is changing.”
He also points out that smaller companies are generally immune to the resentment that afflicts many big corporates. “No one resents a small entrepreneur made good,” he says.
Of course, even if small caps benefit in relative terms it does not preclude the possibility that the world economy as a whole could suffer. The possibility of a trade war between the US and China is perhaps the most dramatic example of a scenario that would do widespread harm.
A related trend to what might be called the national shift, at least in the US and to a lesser extent in the UK, is for greater fiscal stimulus (see Pendulum swings towards more fiscal stimulus, IPE January 2017). That is, attempts to bolster economies by lowering taxes or increasing public spending or have some combination of the two. President Donald Trump’s proposed tax cuts and infrastructure packages are the most high profile but there has also been talk of possible stimulus in the euro-zone. The strong performance of smaller company stocks in the wake of Trump’s presidential election victory seemed to be mainly in anticipation of a boost from tax cuts. Just before he took office in January he proudly tweeted that small business confidence was at a 12-year high according to a survey by the National Federal of Independent Business.
The stage of the economic cycle also has some bearing on the relative fortunes of companies at different ends of the market capitalisation spectrum. Smaller companies tend to be more cyclical with larger ones, on average, more defensive. So smaller firms would, on average, be expected to do better than large ones in economic upturns and worse in downturns.
Before exploring the impact on small and mid caps in more detail it is important to appreciate some caveats. The shifts being discussed are relative rather than absolute. For example, global trade is far from free at present and even President Trump is not advocating an autarkic system where the US cuts itself off from the global economy. Instead the talk is of a shift in the balance towards one more focused on economic nationalism and on bilateral trade deals rather than multilateral ones (see briefing in this issue). But with total world trade running at about $21trn (€20trn) in 2015 according to the latest World Trade Organization figures, even a slight tilt could amount to a considerable sum.
Similarly, the movement of people across borders is hardly free at present. As Mexicans trying to enter the US or North Africans wanting to migrate to Europe will testify, there are already considerable obstacles in their way. Nevertheless, a further tightening of migration rules could still have a significant effect. Many companies fear a rise in the price of labour and a shortage of critical skills.
Finally, it should be remembered that globalisation looked like it had peaked several years before the emergence of the discussion of populism in 2016. IPE ran an article on this topic in December 2013 (Outlook 2014: De-globalisation) quoting studies saying that globalisation probably peaked in about 2006. It is not that, for example, world trade stopped growing then but the rate fell sharply (even stripping out the trade slump in 2009 and recovery in 2010). Before the 2008-09 global financial crisis trade was growing at about twice the rate of economic output, whereas since then they have grown at about the same rate. The significance of recent political developments is not that they could stop globalisation, that has arguably already happened, but that it could go into reverse.
Of course, small cap managers will argue, quite reasonably, that they do not invest in the whole universe but in a select number of the best stocks. In that respect, Kempen is typical. “We don’t overly focus on the macro,” says Tommy Bryson, joint head of the European small-cap team. “Small caps are a very, very deep universe. For example, we invest in 30-50 stocks of about 950 available in the MSCI Europe index. Bottom-up stockpicking can really come into its own in the smaller company sector.”
For anyone thinking about asset allocation more broadly it makes sense to consider the strengths and weaknesses of small caps as an asset class. These can vary according to time and place. What works well in one set of circumstances does not necessarily work well in another.
In considering the impact of greater protectionism it is again advisable to note the difference between a relative and an absolute impact. Matthew Dobbs is certain the impact would be negative overall. “Putting up barriers to trade or having less flexibility in your labour market is not great for any economy and it’s not great for your corporate sector, large cap or small cap,” he says. “They are just bad policies”.
However, under some circumstances it is possible for small caps to do well relative to large caps. “In trying to run small cap money it’s rather difficult to know quite how this is going to pan out. If a greater protectionism is also part and parcel, particularly in the US, of more fiscal stimulus, less on the monetary side and more trying to get the economy going, then obviously that’s in many ways quite favourable for smaller companies.” Indeed small caps did strikingly well relative to large caps in the wake of Trump’s election victory.
Discussion of a fiscal stimulus and tax cuts in particular seem to have powered the strong performance of US small caps. “Small caps performed extremely well in the aftermath of the election and I think probably the biggest driver of that has been some expectation of lower tax rates,” says David Lefkowitz, a UBS equity strategist based in New York.
A similar view is taken by Ward Sexton, a small-cap fund manager at William Blair, a Chicago-based investment banking and asset management firm. “Lower taxes should be a benefit for small caps. They tend to have 10-15% more revenue sourced domestically,” he says. “If tax rates are reduced as Trump has proposed it would be really meaningful to the bottom line of a lot of companies.”
One reason why small companies seem to have benefited more from the proposed tax cuts is that they tend to pay proportionally more tax in the first place. In contrast, the largest companies tend to be more international and get more of their revenue from abroad. They also often have more advanced tax planning. “If you don’t pay much in taxes a reduction in taxes is not necessarily a big lift,” says Sexton.
The situation in Europe, particularly in the euro-zone, is different for several reasons. For a start there is little sign of a fiscal stimulus despite some talk of the need for one. Germany in particular has stood out against such action despite having the economic strength to pursue one if it wanted. Indeed, Germany’s trade surplus surged in November, on top of already strong performance. Yet in the view of its current leaders, a stimulus programme would threaten to stoke up problems such as inflation in the future.
German politicians are sensitive to the charge that domestic taxpayers would in effect be bailing out weaker economies in the euro-zone. Many Germans resent what they see as their hard-working compatriots subsidising profligate spending in some other euro-zone member states. A similar strand of national resentment is apparent in euro-zone countries such as Finland and the Netherlands. Such fiscal conservatism is far from universal but it does represent a barrier to implementing any stimulus package.
Mark McCullough, joint head of the European small-cap team at Kempen alongside Bryson, does not see any likely shift to fiscal stimulus in the euro-zone at least until the national elections in France, Germany and the Netherlands due this year. “I don’t see any fiscal buttons being pushed ahead of that,” he says. There are several different permutations of the election outcomes but there must be at least some chance that policy will shift after the elections. For example, a Red-Red-Green coalition government in Germany (consisting of Social Democrats, the Left party and the Greens) would probably be more amenable to stimulus than one including the Christian Democrats.
US companies could also arguably benefit from the Trump administration’s deregulation agenda. Dana Emery, the CEO of Dodge & Cox, a San Francisco-based asset manager, says
she would welcome some of the more over-zealous aspects of financial regulation being scaled back. “We think the regulatory response to the financial crisis was very intensive and there is potential for some of it to be rolled back a bit as well, especially in the area of financials such as Dodd-Frank [the 2010 Act].” She also sees some scope for loosening healthcare and environmental policies.
In contrast, Sexton does not see the repeal of the Affordable Care Act (Obamacare) as having a great impact in investment terms. For him it is the long-term trends that are important in this arena rather than who is in power. “The reality is of ageing demographics and rising health care costs,” he says. For example, he says that home health care – that is the treatment of relatively serious illnesses or injuries at home rather than in a hospital – is likely to win further support. He says that it usually costs less and the outcomes are generally better. “It ticks all the boxes for all those involved,” he says.
Indeed the differences between Europe and the US are not confined to policy. The US looks set for a further spurt of economic growth while the euro-zone is still suffering from sluggish performance. Since small caps tend to do best in the early stages of growth it is US firms that are generally doing better at present. This situation could of course be reversed at a different stage of the economic cycle.
Lefkowitz argues that US small caps are particularly vulnerable to anxiety over growth owing to their high levels of debt at present. “If we do have any growth concerns you could see more down side in small and mid caps versus large caps because of that higher level of leverage,” he says.
A related question to bear in mind is currencies. The strength of the dollar – which has trended upwards on a trade-weighted basis since mid-2011 – has generally benefited US small caps as well as non-US companies that have a high proportion of their revenues in the US currency. In contrast, European small caps are at present on the wrong side of this relationship.
The issues raised in this introduction are discussed in more detail in subsequent articles in this report. Without doubt the small and mid-cap sector is vast with a myriad of diverse investment opportunities. But those allocating assets to this arena would do well to consider how the changing political and economic environment shifts the context for investment.