Are Small-Cap Earnings in Trouble?

Are Small-Cap Earnings in Trouble?

Royce co-CIO Francis Gannon looks at the earnings picture for small-caps versus large-caps and sees a silver lining for earnings-focused active managers.

Concerns have surfaced recently in the financial press about the ongoing strength of small-cap earnings on both an absolute basis and relative to their large-cap peers.

The first line of reasoning in each piece more or less parallels what we argued earlier this year—that policies designed to reinvigorate the U.S. economy, including a reduction in the corporate tax rate, infrastructure spending, and deregulation, stood to give a greater boost to domestic small-cap stocks, which saw the lion’s share of gains in the postelection rally.

However, with earnings season just getting under way, small-caps face a potential obstacle to earnings growth in the form of the stalled policy agenda of the new Administration, which is invoked in both stories as one of the primary reasons large-caps are likely to push past small-caps this year. Another reason is the renewed strength of the global economy.

With U.S. fiscal policy on hold and the global economy showing encouraging signs of life, the argument is that large-caps are better positioned for robust earnings growth than their more domestically oriented small-cap peers.

Recent returns arguably show that many investors would concur—the small-cap Russell 2000 Index has been essentially flat since hitting a 2016 high on December 9th while the large-cap Russell 1000 and S&P 500 Indexes have advanced.

However, it also merits mentioning that small-caps were in very good shape from an earnings and market performance perspective prior to the election, with the Russell 2000 comfortably ahead of both large-cap indexes year-to-date in 2016 as we headed into the election.

So we don't see small caps as being in great danger of a significant correction or a major earnings slump. Perhaps more important is our contention that the articles may well be correct in their respectively downbeat assessments of the overall earnings picture for small-cap and large-cap stocks over the short term. Large-caps—as a whole—may do relatively better in the months ahead.

As bottom-up small-cap specialists, however, we are much more focused on the earnings potential of individual companies, not the small-cap index, and our expectation is that most companies we favor, lodged as many of them are in economically sensitive cyclical areas, should be all right. To be sure, in many cases their strong earnings history or potential to recover was a major reason for their appeal to us.

This is especially the case for those companies with a global reach of their own—these businesses are as excited as any of their larger counterparts about the prospect of an expanding global economy.

We also invest in several companies that are domestic suppliers to bigger U.S. firms which themselves have wide-ranging global businesses. So while many appear strictly domestic on the surface, their end markets are worldwide and thus can also potentially participate in any acceleration in global growth.

Many of them are tech-based component makers that are already participating in the global technology buildout that encompasses artificial intelligence, autonomous driving, public and private cloud storage, and the expansion of the semiconductor industry in China.

So even with increased uncertainty about the short-term pace of domestic growth, we are still highly encouraged by the earnings potential for many small-cap companies.

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