Trump Win: Tariffs, tax cuts and less regulation may help Small Cap stocks

As originally appeared in The Jerusalem Post on November 8, 2024.

The day after the election of Donald Trump was full of euphoria on Wall Street. The stock market surged at the prospect of lower taxes, repealing onerous regulations and the prospect for strong economic growth. Leading the market charge higher was small-cap stocks.

As expectations for economic growth have risen, so too has the U.S. dollar. The combination of a strong economy and dollar has historically favored small-cap companies, which benefit from economic expansion with less exposure to the effects of a stronger dollar. Large multinational companies have potential problems with a strong dollar as their products are more expensive for international buyers. In addition, the prospect of tariffs on foreign goods to level the international-trade playing field, should benefit smaller companies that both produce and sell their goods domestically, in the US.

Growth

In an investing world that has been dominated by 7 well-known super large companies, for many years, small cap stocks have become a forgotten asset class for many investors. When I speak to clients about investing in small-cap stocks I often see a pained look on their faces. Why invest in some company that you have never heard of when you can buy Apple instead? After all rare is the situation when anyone, me included, actually recognize the names of these small companies. A few years ago, Brian Bolan of Zacks.com cited 2 other risks for small-cap stock investing, “Lack of insight: Wall Street focuses on the biggest firms. So you have 47 analysts covering Apple, but virtually no one reviewing the merits of the stocks under $1 billion in market cap. Lack of News: The investment media is no different. So the TV networks, magazines and websites rarely give much attention to these smaller firms.”

So, the question is why should anyone invest in them?

The answer to that question lies in historical returns. Obviously historical returns are no indication of future results but I think we can learn a lot from history. In a slightly dated but still relevant article, Paul Merriman wrote, “small-cap stocks are an essential part of a well-diversified equity portfolio. Let’s look at some of the data behind that assertion. From 1928 through 2014, U.S. small-cap stocks turned in a compound annual return of 12.2% (compared with 9.8% for the Standard & Poor’s 500 Index.” Not too shabby.

Not all rosy

Over the last decade, they have produced much lower returns than their large-cap counterparts. This even though they have achieved stronger earnings growth than the big companies. Sitara Sundar of JP Morgan writes, “high-quality smaller-cap stocks now trade at a near-record valuation discount versus their large-cap peers, despite having similar cash flows and profit margins. We believe that gap will narrow, creating a potential entry point.”

Investors are also getting excited that the Trump administration will encourage corporate mergers and acquisitions (M&A). Explaining the attractiveness of the sector Sundar writes, “What explains that earnings growth differential? First, many Small and Mid-cap companies (SMID) are at the leading edge of innovation. That might involve developing breakthrough software or advances in industrial automation. Second, leading SMID-cap companies have streamlined business models with embedded competitive advantages in order to build – and sustain –leadership in fragmented markets. They’re the proverbial “big fish in a small pond. Not surprisingly, a combination of innovation and market dominance makes SMID-cap companies ideal targets for M&A activity. Over the past 30 years, 96% of public M&A targets in the United States have been SMID-cap firms. Last year, the average premium that large-cap companies paid to acquire SMID-cap companies reached 50%, a post–global financial crisis high.”

Risks

While it sounds great, keep in mind that this asset class can be very volatile. Short term investors are playing with fire if they decide to invest in small caps. Actually it’s good advice for investors with a short-term horizon to always forgo investing in stocks. They are just too volatile to invest in for a year or two. Many of these smaller companies are loaded with debt, and if interest rates stay higher for a longer period of time, it could cause serious financial stability issues for them.

How to invest?

I would strongly recommend not investing in individual companies unless you are prepared to do a lot of your own research. The best way for most investors would be to either buy an Exchange Traded Fund(ETF) that tracks small-cap stocks or look for a mutual fund that invests in them.

The long-term historical performance coupled with the prospects of a much stronger economy as well as a stronger US dollar, seems like the perfect recipe for small-cap stocks to do well. Of course there are risks, so be sure to do your fair share of research. Speak to you financial advisor to see if this asset has a place in your portfolio.

The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc. or its affiliates.

Aaron Katsman is the author of Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing (McGraw-Hill), and is a licensed financial professional both in the United States and Israel, and helps people who open investment accounts in the United States. Securities are offered through Portfolio Resources Group, Inc. (www.prginc.net). Member FINRA, SIPC, MSRB, SIFMA, FSI. For more information, call (02) 624-0995 visit www.aaronkatsman.com or email aaron@lighthousecapital.co.il.