Why small companies' stocks keep lagging Corporate America's giants

Posted February 7, 2020 12:32 p.m. EST

— The US economy continues to help prop up the rest of the globe. Jobs growth is strong. Wages are rising. The housing market is robust. And the services sector is booming.

So why are the stocks of small American companies that do most of their business domestically lagging blue-chip titans in the Dow and S&P 500, such as Apple, McDonald's and Disney? Those companies have more exposure abroad and coronavirus, trade and Brexit concerns are hurting them.

The Russell 2000, an index of small US firms that includes companies like Ugg maker Deckers, Kentucky Derby racetrack owner Churchill Downs and Taser manufacturer Axon, is up 10% in the past twelve months.

That's not bad, per se. But those gains pale in comparison to the 16% jump in the Dow, 23% surge in the S&P 500 and more than 30% pop in the tech-heavy Nasdaq over the past year.

Investors appear to be flocking more to large companies because they hope that profits abroad will improve this year -- despite the coronavirus outbreak -- because trade tensions between the United States and China have eased. That's good news for multinational firms.

But some experts argue that it's time for smaller American companies to shine. If the broader market continues to get whipsawed by worries about the coronavirus, investors might seek safety in smaller domestically focused firms.

The case for small caps to shine

"Small caps have done well in times of market volatility. If we see heightened market volatility and some economic slowing later in 2020 and into 2021 and experience a turning point in the economic cycle, we may see US small caps begin to dominate," said Erik Norland, senior economist with CME Group in a report last week.

Smaller companies could also benefit if investors finally grow tired of throwing their money blindly into passive index funds, which are dominated by the largest tech companies in the S&P 500 -- Apple, Microsoft, Amazon, Google owner Alphabet and Facebook.

Investors might start looking for companies that can post stronger gains in sales and earnings over the next few years, especially if the global economy slows. That should favor smaller, more nimble US stocks.

"Small-caps will be a leader. I think we will have, in general, a lower return profile for the whole decade, and I think it'll be a stock picker's market," said Chuck Royce, chairman and portfolio manager of Royce Investment Partners, in a podcast last week.

Larger firms still may have a leg up

Still, some argue that small companies continue to face big disadvantages compared to larger rivals.

Investors seem more willing to tolerate poor financial performance from big brand name firms than from smaller upstarts, analysts at Zacks Investment Research pointed out in a recent report.

According to Zacks, about 75% of the large cap stocks that reported losses in the past year posted an increase in their share price in the past 12 months. But the stocks of only 41% of all unprofitable firms rose during the same time frame.

"Smaller companies are not getting the same treatment as large-caps," the Zacks analysts wrote.

That sort of makes sense. Investors may be more forgiving of short-term losses from companies they've heard of and whose products they use. It's common for larger firms, particularly tech companies, to post red ink when they are in expansion mode.

Small US companies face another hurdle. Trade tensions may actually wind up hurting them even if they aren't producing many goods to be sold overseas. That's because tariffs on components like imported steel and aluminum will raise manufacturing expenses. Wages are rising across America too.

"Small cap companies have seen costs increase faster than demand while productivity is likely quite weak," said Sebastien Galy, senior macro strategist with Nordea Asset Management, in a report.

Larger companies are in a better financial position to absorb some of those higher costs without feeling the need to pass them on to their customers. That may not be the case for smaller American firms. So the Davids of the stock market may not slay the Goliaths after all.

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