{"id":10857,"date":"2018-07-12T16:49:24","date_gmt":"2018-07-12T21:49:24","guid":{"rendered":"http:\/\/www.cambridgeassociates.com\/insight\/ca-answers-should-investors-boost-their-exposure-to-us-small-caps-in-light-of-recent-economic-policy-and-geopolitical-developments\/"},"modified":"2025-12-15T10:04:11","modified_gmt":"2025-12-15T15:04:11","slug":"ca-answers-should-investors-boost-their-exposure-to-us-small-caps-in-light-of-recent-economic-policy-and-geopolitical-developments","status":"publish","type":"post","link":"https:\/\/www.cambridgeassociates.com\/en-as\/insight\/ca-answers-should-investors-boost-their-exposure-to-us-small-caps-in-light-of-recent-economic-policy-and-geopolitical-developments\/","title":{"rendered":"Should Investors Boost Their Exposure to US Small Caps, in Light of Recent Economic Policy and Geopolitical Developments?"},"content":{"rendered":"

We don\u2019t believe so. US small caps have benefited from cyclical tailwinds this year, including strengthening US growth and their more domestic orientation (helpful as the dollar strengthens and trade frictions increase), with small-cap earnings estimated to grow twice as fast as large-cap earnings in 2018. However, rising interest rates could harm small caps disproportionately, the profitability gap between large caps and small caps remains historically wide due to structural forces, despite some recent help from corporate tax reform, and today\u2019s extreme valuations likely reflect\u2014or even overstate\u2014their potential benefit from the Trump administration\u2019s policies.<\/p>\n

Small caps have historically paid higher effective taxes than large caps at the aggregate index level and therefore would appear to benefit disproportionately from the recently passed corporate tax reform, but the devil is in the details. It\u2019s true that large caps generate a higher proportion of their profits overseas than small caps and have taken greater advantage of offshore tax havens. Yet, 34% of Russell 2000\u00ae companies (representing more than 25% of the index\u2019s market cap) had negative\u00a0pre-tax income last year\u2014a much higher proportion than normal\u2014and therefore did not pay any taxes. Stripping out unprofitable companies eliminates most of the difference in tax rates between large and small caps, and the benefits of tax reform would seem to mostly accrue to a smaller subset of stocks rather than the small-cap universe as a whole.<\/p>\n

Small caps in aggregate have higher debt burdens than large caps, with interest expenses consuming more of their cash flow. Russell 2000\u00ae debt issuers have much lower credit quality on balance than S&P 500 issuers (of the roughly 400 Russell 2000\u00ae members with debt rated by Standard & Poor’s, only 10% are investment grade, compared to 86% of S&P 500 companies), and this raises the cost of debt for small caps. Small caps are also more exposed to rising rates and refinancing risk than large caps, with floating-rate debt making up nearly half the outstanding debt load for Russell 2000\u00ae issuers (excluding financials and real estate), and with near-term maturity walls for many.<\/a>*<\/a> By comparison, large caps have been quite successful this cycle in locking in long-term, fixed rate financing at historically low rates; approximately 91% of debt for the comparable S&P 500 universe is fixed rate. Although floating rate borrowers have likely hedged out at least some of their exposure, hedges cost money and eventually expire. Rising interest rates are boosting debt-servicing costs for small caps more than for large caps, and the increase may offset any benefit to net profit margins and free cash flows from the recent tax cuts for certain small-cap stocks.<\/p>\n

The profitability of US large caps has exceeded that of US small caps over time, including within individual sectors, and the drivers of this appear more structural than cyclical. The relative return on equity spread between the Russell 1000\u00ae and Russell 2000\u00ae currently remains close to the highest level in nearly 40 years of observations. Possible drivers include the larger fixed-cost burden on small caps from regulatory and administrative costs associated with being public, and small caps\u2019 more limited success reducing\u00a0production costs via globalization. A bloom of unprofitable small-cap biotech IPOs over the past decade and small caps\u2019 higher R&D and capex investment (in part to compete with well-funded private peers), which are expensed under current accounting rules, have also weighed on margins at the index level.<\/p>\n

Despite these structural margin pressures and the potential impact of rising rates, US small-cap shares remain on a \u201csugar high\u201d on the back of tax cuts, relative economic strength at home versus abroad, and their more domestic tilt. Relative to history, small-cap valuations today are top decile across a variety of metrics and would make for disappointing prospective returns if valuations revert toward long-term average levels.<\/p>\n

Thus, we retain conviction in our underweight call on US small caps, despite cyclical tailwinds and a somewhat greater one-time profit boost from tax cuts. Of course, investors who are confident they can source active small-cap managers that can add value prospectively on a risk-adjusted basis relative to the broad US equity market (and not just against the dedicated small-cap benchmarks) may be comfortable with neutral-weight or even above-market allocations. We continue to believe the US small-cap space should be viewed as a potential alpha play, but not as a beta trade.<\/p>\n","protected":false},"excerpt":{"rendered":"

We don\u2019t believe so. US small caps have benefited from cyclical tailwinds this year, including strengthening US growth and their more domestic orientation (helpful as the dollar strengthens and trade frictions increase), with small-cap earnings estimated to grow twice as fast as large-cap earnings in 2018.<\/p>\n","protected":false},"author":26,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"_searchwp_excluded":"","footnotes":""},"categories":[136],"class_list":["post-10857","post","type-post","status-publish","format-standard","hentry","category-market-insights-en-as","topics-public-equity-en-as"],"acf":[],"yoast_head":"\nShould Investors Boost Their Exposure to US Small Caps, in Light of Recent Economic Policy and Geopolitical Developments? - Cambridge Associates<\/title>\n<meta name=\"description\" content=\"Cambridge Associates analyzes whether investors should boost US small caps exposure amid economic policy changes. 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