Donald Trump’s surprise victory in the 2016 U.S. presidential election brought with it a wave of optimism that the incoming pro-growth, pro-business administration would drive another leg up in the lengthy equity bull market. Many thought that U.S. small-cap stocks, given their domestic focus and relatively high effective tax rates, were particularly well positioned to benefit from corporate tax reform, one of the major planks of the Republican Party platform.
Enthusiasm among investors for a lower statutory corporate tax rate could be seen in the funds flow data. As shown below, flows into passive small-cap equity strategies spiked in the aftermath of Trump’s victory; for the three-month period surrounding the presidential election (November 2016 through January 2017), $25 billion flowed into passive small-cap strategies—roughly six times the average three-month flow over the past 10 years. Flows into passive large-cap products also increased during the election period, though to a much smaller degree. After the initial euphoria, however, flows in 2017 settled into a more volatile pattern dictated by fluctuating expectations for the Trump administration’s ability to enact its agenda. With the performance of the small-cap market closely tied to fund flows in the post-crisis years (for reasons we’ll explain later), the relative performance of the small-cap Russell 2000 versus the S&P 500 has followed a similar trajectory since the election.
While we would argue that blindly buying exposure to the small-cap market via benchmark-mimicking passive investment strategies isn’t an optimal approach under most circumstances (see our May 2017 white paper), we believe that it is particularly inefficient for those investors hoping to capitalize on the tax plan’s potential impact in this space. What seems to have been widely overlooked in the latest rush into passive small-cap strategies is that the new tax rate will benefit only those companies that pay taxes—meaning a significant portion of the Russell 2000 will be excluded.
Are Investors Using Small-Cap Indexes as a Proxy for Tax-Reform Beneficiaries?
Source: Jefferies Group. Through November 30, 2017.
Lower Corporate Taxes, but for Whom?
With a median effective corporate income tax rate of nearly 32% for Russell 2000 companies, it’s easy to see why investors would be attracted to the prospect of a much lower statutory rate than the existing 35%; though 15% had been bandied about on the campaign trail, lawmakers ultimately settled on a still-significant 21%. Great, right?
While identifying the individual names that stand to benefit most from a lower tax rate involves more analysis than is appropriate for this forum, it’s pretty easy to spot those who will not benefit: the approximately one-third of the Russell 2000 that lost money in 2016, as companies with zero income have zero tax liability. This percentage is cyclical and varies over time, of course, and some of these companies could become profitable in the coming years. Even companies within the S&P 500—which unlike the Russell 2000 has certain quality criteria, including profitability, for entrance—lose money on occasion. About 10% did in 2016, in fact.
That said, secular trends here are troubling, particularly the difference between the relative percentage of loss-making companies in the Russell 2000 versus those in the S&P 500. As you can see in the figure below, the ratio of money-losing companies recently eclipsed the peak of the dot-com mania, the acknowledged gold standard for speculation, as the small-cap index continued to deliver higher lows and higher highs in this metric.
The Ratio of Loss-Making Companies in the Russell 2000 vs. the S&P 500 Is Trending Higher
As of September 30, 2017
Source: Furey Research Partners, FactSet.
Note: The % of loss-making companies is calculated by determining the number of benchmark holdings that have negative trailing GAAP earnings and dividing that total by the total number of names in the overall benchmark. This information is calculated for both the Russell 2000 and the S&P 500 on a quarterly basis over time.
The Passive Limitation
Passive investment strategies merely mimic an index and thus, by design, are unable to distinguish between a company that generates earnings and the 30%-plus that lose money. With nearly all passive small-cap vehicles employing a market-cap-weighted approach to portfolio construction, passive money simply flows into all of the stocks within an index according to their relative size. These flows—and not business fundamentals—have been the primary driver of small-cap asset pricing in recent years, driving correlations higher and fueling the outperformance of passive strategies relative to active ones.
Capitalism is predicated on the concept that capital—relatively scarce and costly—is directed primarily to the most deserving business models, enabling them to thrive; undeserving models, in contrast, are denied capital and thus wither and inevitably collapse. This “creative destruction” has been lacking in the post-crisis liquidity environment, and price inefficiency and capital misallocation have been the unavoidable result of passive investing’s dominance in recent years. The tax-bill-related inflows into passive small-cap strategies—independent of the fact that one-third of the companies targeted by these inflows are not positioned to benefit from the tax cut—are just another example of this trend.
The Active Solution
We believe that active and passive strategies both are likely to continue to play an important role in small-cap equity asset allocation. While passive approaches have proven effective in lowering fees and enhancing returns for investors, until equities are viewed as fungible commodities, active management will continue to be the means by which investors can seek to efficiently allocate capital.
Money-losing companies tend to underperform profitable ones over the long term. While accommodative post-crisis central banks have buoyed money-losing companies in recent years, history has shown that the success of unprofitable companies tends to be unsustainable. While a number of other evolving factors need to be considered in any assessment of the small-cap equity market, including everything from the impact of rising interest rates on leveraged companies to the new curbs on interest-expense deductibility, we believe profitable companies—i.e., those actually positively impacted by the lower corporate tax rate—in general likely will be repriced higher as the market recognizes their potential for improved earnings momentum.
We also believe that the ideal way to skew a portfolio toward such high-quality, earnings-generating small-cap companies—and away from money-losing entities with poor business models and shaky future prospects—is through active management. The significant flows into passive small-cap strategies triggered by recent tax policy changes are merely one illustration of the price inefficiency that active mangers such as ourselves seek to exploit.
In Case You Missed It
- NAHB Housing Market Index: -2 to 72 in January
- Euro zone Consumer Price Index: +0.4% in December month-over-month and +1.4% year-over-year
- China 4Q17 GDP: +6.8% annualized rate
- U.S. Housing Starts: -8.2% to SAAR of 1.19 million units in December
- U.S. Building Permits: -0.1% to SAAR of 1.30 million units in December
What to Watch For
- Tuesday, 1/23:
- Bank of Japan Policy Decision
- Wednesday, 1/24:
- U.S. Existing-Home Sales
- Thursday, 1/25:
- U.S. New-Home Sales
- European Central Bank Policy Meeting
- Japan Consumer Price Index
- Friday, 1/26:
- U.S. Durable Goods Orders
- U.S. 4Q17 GDP (First Estimate)
Statistics on the Current State of the Market – as of January 19, 2018
|S&P 500 Index||0.9%||5.2%||5.2%|
|Russell 1000 Index||0.9%||5.1%||5.1%|
|Russell 1000 Growth Index||1.2%||6.2%||6.2%|
|Russell 1000 Value Index||0.5%||3.9%||3.9%|
|Russell 2000 Index||0.4%||4.1%||4.1%|
|MSCI World Index||1.0%||5.0%||5.0%|
|MSCI EAFE Index||1.2%||5.0%||5.0%|
|MSCI Emerging Markets Index||2.0%||6.4%||6.4%|
|STOXX Europe 600||1.3%||4.9%||4.9%|
|FTSE 100 Index||-0.6%||0.6%||0.6%|
|CSI 300 Index||1.4%||6.3%||6.3%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||-0.1%||-0.2%||-0.2%|
|Citigroup 10-Year Treasury Index||-0.7%||-1.8%||-1.8%|
|Bloomberg Barclays Municipal Bond Index||0.1%||-0.4%||-0.4%|
|Bloomberg Barclays US Aggregate Bond Index||-0.4%||-0.9%||-0.9%|
|Bloomberg Barclays Global Aggregate Index||0.2%||0.5%||0.5%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.2%||0.7%||0.7%|
|ICE BofA Merrill Lynch U.S. High Yield Index||-0.1%||0.6%||0.6%|
|ICE BofA Merrill Lynch Global High Yield Index||0.1%||1.0%||1.0%|
|JP Morgan EMBI Global Diversified Index||-0.2%||0.0%||0.0%|
|JP Morgan GBI-EM Global Diversified Index||0.5%||3.0%||3.0%|
|U.S. Dollar per British Pounds||1.2%||2.4%||2.4%|
|U.S. Dollar per Euro||0.6%||1.8%||1.8%|
|U.S. Dollar per Japanese Yen||0.6%||1.8%||1.8%|
|Real & Alternative Assets|
|Alerian MLP Index||-1.5%||7.6%||7.6%|
|FTSE EPRA/NAREIT North America Index||0.2%||-4.8%||-4.8%|
|FTSE EPRA/NAREIT Global Index||0.8%||0.0%||0.0%|
|Bloomberg Commodity Index||-0.2%||0.5%||0.5%|
|Gold (NYM $/ozt) Continuous Future||-0.1%||1.8%||1.8%|
|Crude Oil (NYM $/bbl) Continuous Future||-1.5%||4.8%||4.8%|
Source: FactSet, Neuberger Berman.