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Make Small Caps Great Again!

12/08/2016

In December 2015, we published “Is This the Time for Small Cap Value?” The answer to that question was and remains the same. Yes! 

Following the worst two-year period for small cap stocks relative to other equities since 1995, market conditions were becoming highly favorable for future returns.  While our attempt to combine humor and finance left some readers scratching their heads, our conclusions proved to be consistent with market outcomes since that time.  We think 2016 will prove to be the first of several years of positive absolute and relative returns.

The 2016 US election results and the forthcoming proposed corporate tax reforms are a game changer, especially for small caps. It is widely known that both the Trump and GOP tax plans include reducing the tax rate from 35% to 20% (or lower) and have provisions to allow US companies to repatriate overseas cash without substantial tax penalty.

Here are a few key points that many investors may not fully appreciate:

  1. The average Large Cap company has an effective tax rate of 28% vs. 36% for Small Caps
  2. These differences are even larger within Sectors
  3. Tax reform proposals include 100% deduction for capital investment, a very big deal
  4. Small Cap company earnings may increase by 20-50% if enacted
  5. Large Caps with overseas cash, would be able to use for domestic M&A

 

LargeCap_Vs_SmallCap_Effective_Tax_Rate.png

Larger taxpaying US companies have enjoyed a growing tax advantage over smaller companies for the past fifteen years. In 2016, the median effective tax rate for companies in the Russell 1000 Index (large caps) was 29%, compared to 36% for companies in the Russell 2000 Index (small caps). In 2002, these figures were approximately equal for both cohorts at 35%. The spread in the effective tax rate advantage of large caps is also the highest it has been.

Recent Cabinet nominations and a Republican majority in all three branches of government suggest that tax reform will be a high priority for the next administration. House Speaker Paul Ryan has also put forth a pro-growth tax relief package that is similar to President-elect Donald Trump’s own tax proposals.

The goal is to make American businesses more competitive globally, where many countries have far lower tax rates. While there are certain provisions that mostly benefit larger companies, namely repatriation of overseas profits at very low rates, we believe the most significant and immediate beneficiaries will be small and medium sized businesses.

SmallCapVsLargeCapTaxRateBySector.png

If enacted, the Ryan/Trump tax plans would not only lower tax rates, but also allow companies to fully depreciate capital investments. This key provision would lower pre-tax income by the amount of capital they invest in the tax year. The lower tax rate is then applied to an even lower taxable income, which would be a windfall for net after tax profits. We began calculating the impact on companies in the Goodwood SMID Cap Universe shortly after the election. The results were no less than staggering.

We used several approaches to quantify both the impact to after tax profitability and to the equity values in various scenarios. Many brokerage firms have published similar exercises using the simple methodology of applying a lower tax rate to consensus forecasts for 2017 and 2018. For many domestic companies with high tax rates, the earnings increase is approximately 20-25% in 2017 from 2016 (all else equal). One can then simply apply a current price-to-earnings ratio to get a sense the implications for equity values. This method may be crude, but it gives a valuable sense of direction and magnitude for potential upward earnings revisions.

SmallVsLargeCapProFormaChangeInNetIncomeBySector.pngWe found it far more interesting when segmenting the data by companies that currently trade at price-to-earnings ratios that are less than their 7 year averages. For this group, the benefit is potentially two-fold: earnings increase from a lower tax rate, and earnings multiples revert to their mean over time. For this subgroup, the implied median equity upside was 40-50% (versus 20-25% for the universe).

Finally, we took this analysis a step further to measure the impact of the corporate tax reform in totality, including key provisions such as the full deductibility of capital expenditures. Companies with high effective tax rates and capital intensive business stand to gain the most.

SmallVsLargeCapProFormaChangeInNetIncomeBySectorWithCapexDeduction.png

When you consider that these are the very same sectors that have seen equity values decline over the previous 2-3 years, you begin to see why we think the next few years could be…..well…..”YUGE”?

We'd love to hear from you. Please leave your thoughts in our comments section below.

 


ABOUT THE AUTHOR

Ryan_Thibodeaux_GoodwoodCapitalManagement

Ryan Thibodeaux is President / Portfolio Manager of Goodwood Capital Management.

Ryan founded Goodwood Capital Management, LLC in March, 2012 and serves as a Portfolio Manager. Prior to starting Goodwood, Ryan was a Partner and Senior Equity Research Analyst with Maple Leaf Partners, LP. Maple Leaf Partners is a long short equity hedge fund started in New York by Dane Andreeff in 1996. In 2003, Julian Robertson’s Tiger Management seeded Maple Leaf and it became what is commonly referred to as a “Tiger Seed.” The firm eventually grew to over $2 billion in assets under management.

To read Ryan Thibodeaux's full bio or other Goodwood team members, click here

 

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