Some of Donald Trump’s plans for the US economy may provide a big boost for small stocks. We think there are five compelling reasons for investors to take a closer look at this segment of the market.

Since Trump won the US presidential election a little more than a month ago, the small-cap Russell 2000 Index has surged some 15%, compared to less than 6% for the S&P 500 Index of large-cap stocks.

What’s going on? Investors are betting that a bevy of proposed Trump polices, including lower corporate taxes, repatriation of cash held offshore and looser regulation, and their likely effects (faster economic growth, higher interest rates, rising inflation), will disproportionately benefit small-cap stocks.

Our research points toward the same conclusion. But that doesn’t mean every small company will be a winner during a Trump presidency. His policies will have varying effects on different companies and sectors. Take regulation. Trump’s plan to relax some postcrisis financial rules is clearly good for bank shares. But repealing the Affordable Care Act could leave millions uninsured, raising costs for hospitals.

Investors will have to navigate plenty of twists and turns, and they will need a steady hand on the wheel. That’s why a hands-on approach that can identify attractively valued stocks with strong fundamentals is still critically important, in our view.

More Change, More Opportunity

For investors, change can mean opportunity—especially when it comes to small-caps. They receive far less attention from analysts than their larger peers, and this neglect often leads to mispricing or misunderstood fundamentals. Today, the potential for both is even greater.

Here’s a look at some key Trump policy priorities and what they could mean for small-caps:

  1. Tax reform: This is the most unambiguously positive proposal for small-caps and a big reason for the market rally. Smaller companies generally have higher tax rates than multinationals, so lower corporate taxes would provide a big boost. Some smaller companies that pay close to the full current corporate rate, such as regional banks and certain consumer and industrial companies, could see earnings rise by 10% to 20% if the rate falls into the 20%–25% range (Display).

Trump And Small-Caps

Small-Caps
  1. Infrastructure: Trump wants to spend up to $1 trillion over a decade, and there’s strong bipartisan support for updating the country’s aging infrastructure. Whatever the ultimate price tag, additional spending should benefit engineering-and-construction and industrial companies. Generally, smaller companies can offer a more targeted and better way to bet on trends like new infrastructure spending than exposure to large multinationals with diversified businesses.
  2. Interest rates: Lower taxes and increased fiscal spending could drive higher inflation and higher interest rates. That’s good for certain regional banks, but bad for interest-rate–sensitive sectors such as real estate investment trusts and utilities, whose shares have underperformed since Trump won and rates rose.
  3. Repatriation of overseas cash: A proposed repatriation tax holiday for companies with cash overseas may also add to inflation. But if it boosts M&A activity, it could benefit smaller-cap stocks disproportionately. Since 1994, small-caps have accounted for 91% of public-company M&A deals. A big potential winner: biotech.
  4. Trade and protectionism: Most small-caps are domestically oriented and generate a smaller portion of their sales overseas than their large-cap peers. That suggests that retreat from existing trade deals should squeeze large companies’ margins harder. But there’s plenty of gray here. Those larger firms that do sell abroad are often customers for smaller-cap companies and may buy less or ask for price concessions. What’s more, trade barriers depress economic activity.

Pick Your Stocks Carefully

On balance, we’re bullish on small-caps and think allocating to this segment of the market can boost investors’ return potential. And while the market has risen sharply over the last month (Display), the rally still seems to have legs. When compared with large-caps, smaller stocks still appear reasonably valued. That’s good news for investors who feared they had missed their chance to increase small-cap exposure.

Trump And Small-Caps

But how they get that exposure matters. Changing rules will create winners and losers. Exchange-traded funds and passive mutual funds that track a small-cap index buy a broad basket of small-cap stocks and can’t interpret how individual companies will react to new policies or economic developments.

It can be risky to make broad judgments about how small-caps will respond to specific policy proposals—which could look very different once they become law. The best course of action is to target companies with strong fundamentals while maintaining the flexibility to react as policy changes become clearer.

In other words, even now, when conditions for performance seem to be falling into place, we think focusing on company-specific earnings drivers is the best way to identify the small stocks that can generate big investment returns.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Article by James MacGregor, Bruce Aronow – Alliance Bernstein

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