BofA: Small Caps Stand To Benefit More Under Trump
Small caps have routinely outperformed large caps since 1926 – delivering 11.4% annual returns versus 9.5% for the larger stocks. They win handily on a number of other criteria too. Yet they are not always on the horizon of investors because of obviously higher risks.
Bank of America Merrill Lynch believes the time might be ripe to look more favorably at small cap stocks again. A key reason: Small caps will stand to benefit far more than large caps under policies likely in the Trump presidency. Lower foreign exposure (21% vs 31% for large caps), a likely cut in corporate taxes, better domestic growth and a rising dollar all suggest small caps stand to gain more than larger cap stocks.
What’s more, for the last three years, small caps have underperformed large caps, suggesting they will benefit more than their larger peers when the U.S. economy rebounds.
“Given that smaller companies tend to be more economically sensitive, small caps typically bounce the most coming out of a recession,” BofA analysts wrote in a note explaining its Endeavor small cap list. “Since no one can predict when recessions will end, we remain advocates of maintaining a diversified asset allocation regardless of market conditions and investing in small caps for the long term.”
Endeavor is a concentrated list of about 15 to 25 smaller cap stocks. American Eagle Outfitters Inc. (AEO), International Game Technology plc (IGT), Nabors Industries Ltd. (NBR), Oasis Petroleum Inc. (OAS) and Magic Investment Corp. (MTG) are the top five on the current list.
Small caps outperform large caps in long-term
Historically, small caps outperform over longer time horizons. Over rolling 12-month periods starting from 1926, small caps beat large caps 54.3% of the time. That number increases with time periods. It rises to 61.2% over five years, to 70% over 10 years, and to 86% over 20 years.
Why is the underperformance of small caps since September 2013 significant?
“Small caps are correlated with risk assets like high yield. Since 2008, small caps have shown a -0.30 correlation with credit spreads, meaning that small caps tend to underperform when credit spreads widen. The increase in the BofA Merrill Lynch U.S. High Yield option adjusted spread by more than 500bp from mid-2014 through February of this year coincided with the significant underperformance in small caps versus large caps. But since February 2016, credit spreads have narrowed close to 300bp, which has helped small caps erase last year’s losses and push the Russell 2000 ahead of the Russell 1000.”
There is also a strong case for portfolio diversification with small caps. Small cap stocks have no overlap to the S&P 500 or Russell 1000, and have a lower correlation (0.86) with returns from large cap stocks, compared with midcaps (0.93).
Finally, small caps may provide better opportunities for active managers to generate excess returns versus the Russell 2000 benchmark.
“Smaller companies tend to have less available information, as shown by the average number of equity analysts covering a stock, which generally creates a better environment for mispricing and adding alpha,” the research note said.
“When there is more differentiation in performance — wider spread between the best and worst-performing quintiles — this is favorable for stock selection. Pair-wise correlations have remained elevated for most of the post-crisis period, suggesting stocks have moved more together, while available alpha (based on long-short performance spreads) has been low.”
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Source: valuewalk