Economics

The Impact Of Tax Reform On Small-Caps

What should small-cap investors know about tax reform and current valuations?

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Small-Cap Industrials
Image source: Wikimedia Commons

What needs to happen to sustain current small-cap valuations?

Valuations are not inexpensive. We can debate as to how expensive they are. At this level, with the hope and expectation of higher interest rates and inflation, again, that normalization process, it's hard to make the case. It's virtually impossible to make the case for higher multiples.

You need earnings growth. And for earnings growth, we need sales growth. One thing that's clear, quantitative easing did not accomplish much in terms of the real economy. It inflated asset prices, but did very little as it affected the real economy.

So, at this stage, we're going to require some action of government. It's either going to be public works kind of projects, infrastructure and the like, or some kind of tax cut/reform, that invigorates, or gives some kind of stimulus to the economy allowing sales to grow more rapidly, which will allow earnings to grow, which would allow prices to advance.

Could a correction come in time instead of in price?

Definitely, that can happen. It historically has happened. If there were time for earnings to truly advance and prices didn't, valuations would be better, and it would give portfolio managers like myself an opportunity to repopulate. It's very difficult to find attractive names in the current environment.

How do you see small-cap companies allocating their tax savings?

It's interesting. My companies, in my portfolio, don't have a lot of debt. Those that have a lot of debt, and if the tax policy has limits on the deductibility of interest, clearly, debt pay down, debt reduction, will be one item that would be focused on. I suspect we're going to get good dividend growth.

Small-cap companies tend to run in niche businesses, and the reinvestment opportunities within those are somewhat more limited. They can obviously try buying someone else. They can do stock repurchases. But I think it will be balance sheet-centric.

I think once the tax policy is pretty much known, I think there will be a removal, or lessening of the hesitation and uncertainty. So, people who were concerned about those issues might indeed proceed with CAPEX.

How might tax reform affect small-caps and the U.S. economy?

Tax reform would definitely help the economy in toto. The degree might vary and unanswered are issues such as the effect on the deficit and so forth. But it's certainly a positive. Small-caps could be benefited several ways.

Most small-cap companies being more US-centric than large-caps pay a fuller tax rate. And, to the extent that taxes decline, earnings would go up. Cash flow would go up.

There's another element that has gotten discussed, but not so much as to the consequences regarding small-caps, and that is the repatriation part of reform. Large companies will be the primary beneficiaries, but when they bring those monies back they have a lot of opportunities as to what to do with it.

But given the stage of the cycle we're in, and the difficulty in further reducing costs at this late stage, I think large companies are going to be prone to acquiring strategic acquisitions, i.e., their competitors. And some of those will be smaller companies. I think I have many of those potential targets in my portfolio. You should get some transactional value appearing in the small-cap names.

The acquiring company, the larger company gets the mathematical accretion that comes with acquisitions. But they also, the reason for doing it, is the synergies that they may be able to employ through reducing factory count paying only once for R&D.

Article By Charlie Dreifus, The Royce Funds