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Small companies are consistently identified as the clear winners from plans to cut US corporate taxes, but the broader outlook for this corner of the capital markets is murky and getting murkier. Analysts at Bank of America Merrill Lynch, for example, are telling clients to avoid the group in favour of large companies in 2018. Small companies tend to be more domestically focused than their larger, often multinational, counterparts. That means they should stand to gain more from a decline in domestic corporate tax rates, but small caps have already done quite well. They gained nearly 20% last year and are up about 12% so far in 2017.
For many of them, that means their valuations are very high. Research by FactSet and Bank of America Merrill Lynch suggests that the Russell 2000 small cap index traded at 19.3 times forward earnings at the end of November. Once unprofitable companies, almost one third of the index, are excluded that is in the 99th percentile of the historical valuation for the index and a level seen only in three other months since 1979.
By contrast, the Russell 1000, an index of large cap stocks, traded at 18.6 times, the 89th percentile for that index. Earnings growth for small caps has also lagged behind that of large caps in each of the past four years and is on track to do so again this year. Tech companies and those most exposed to China have been engines of growth and neither is strongly represented among US small caps.
Debt levels too at US small caps are high by historical measures. Small companies will face more pressure from the rising cost of debt if interest rates rise, because they tend to be more reliant on external capital to grow than large companies, which can fund themselves more through the money they earn and while corporate tax cuts will help small caps, those with significant debt could also be hurt by other measures in the tax package. The Senate and House plans, which are currently being merged, both limit debt interest benefits depending on income. When tax cuts and the new limits are balanced out, some companies will emerge as losers.