US small caps due for a catch up

Just in case the doomsayers about the current strong US economy and its durability, have got it wrong, and the current US expansion proves more durable than they expect, we have looked at Small Cap Value Stocks, which have lagged well behind Large Cap Growth.

The main beneficiary of a strong US economy thus far has been Large Cap Growth, which we recently described as also benefitting from an equity drought.

Small Caps will be the major beneficiaries from lower corporate tax and protectionism and are due for a catch up.

In the last 12 months the Large Cap S and P 500 (SPY) is up 20 per cent. The Vanguard Small Cap Value ETF (VBR) is up only 12 per cent. The gains over four years have been 46 per cent for SPY and 37 per cent for VBR. Large Cap growth has trumped everything thus far. The gains in the markets have been highly concentrated.

The original research by Fama and French added size and value factors to the market risk factor in the Capital Asset Pricing Model and includes the fact that value and Small Cap stocks outperform markets on a regular basis.

Australian investors with a predisposition for dividends will find a lot to like in Small Cap Value.

Much of the market’s early rally has been attributed to the election of Trump and his pro-business stance. Again, much of that was on the promise of growth. When GDP starts to rise, large caps are often the first to benefit. When the local US economy starts to improve ( not just the much larger international businesses) small caps start to benefit.

The doomsayers may have missed the fact that Gross Domestic Product in the USA expanded by 5.2 per cent in the third quarter.

The economists and America’s trading partners may not like it, and like Trump’s election the reality has still not sunk in. America is becoming more protectionist and small caps will be the first beneficiaries.

The average small-cap stock in the U.S. gets less than 20% of its sales from overseas. This compares to over 30% for large-caps. Secondly, any cuts to corporate taxes will have a greater impact on small caps which have not had the ability to reduce corporate tax rates below 35 per cent. The end of the nanny state with less regulation will help small-caps who don’t have the money to hire expensive lawyers.

Should we start to get inflation resurgent small cap stocks are usually better able to raise prices as I found out this weekend when it cost me $100 to have my gutters cleaned versus $60 last year.

Rising volatility, a weaker dollar, and a better credit environment will all help.

For most investors (and mainly because the major equity analysts have almost abandoned small cap research) the answer will be to choose an Exchange Traded Fund.

For familiarity as well as its low cost we have chosen the Vanguard Small Cap Value ETF (VBR). We are grateful to ETF Research Center for its numbers.

The VBR currently trades at

17 times forward earnings

1.8 times Price to Book

on a yield of about 2 per cent.

$100 invested in Jan 2013 would be worth $200 today equivalent to an annualized rate of 15.4 per cent.