Small-cap investing is on life support

Since Donald Trump’s surprise election victory in 2016, stocks of small companies have fallen behind larger companies, reversing a long-held trend. That has some investors bearish on the asset class, with a number of fund managers betting that current political and market dynamics will continue to favor bigger companies. Erik Weisman, chief economist at MFS Investment Management, believes that the basic fundamentals of investing in companies with smaller capitalization have turned. While small caps have historically been a big-risk, big-reward gambit for investors, Weisman argues that the reward may increasingly be shrinking. Whereas small companies previously drove innovation by disrupting bigger companies with new technologies and ideas, today many large companies can simply buy competitors to generate growth in-house. Decreasing regulations play a role but so does the changing nature of big businesses, particularly in the United States and China. “If big companies like Alibaba, Amazon, Facebook, Tencent are just going to keep on winning, then the concept of buying small caps changes,” Weisman told Yahoo Finance in a phone interview. “In a world where winners take all and just keep on winning, we don’t see small firms that show up on the public playing field.”

Technology, this year’s best-performing sector, hasn’t been this big in more than 17 years.
Technology, this year’s best-performing sector, hasn’t been this big in more than 17 years.

Weisman noted that in traditional companies, such as automobile manufacturers, at some point increasing production leads to decreasing returns. But in digital platform companies like Amazon and Facebook, it’s not just that they can, but they must continue to grow.

Wealth is being redistributed

And it’s not just technology companies that are continuing to grow unimpeded. Pharmaceuticals, beer companies and airlines have also continued to grow by swallowing up competitors in major mergers. The combination of increasing mergers and acquisitions with a decreasing number of initial public offerings has reduced the number of public companies to its lowest level in at least 40 years. Additionally, the companies that do come to market are increasingly doing so at a much higher level of capitalization, meaning they no longer qualify for many small-cap investors’ mandates. Research from Thomson Reuters show that U.S.-listed IPOs so far this year total $11.4 billion from 30 offerings, more than double the proceeds raised a year ago and the highest year to date period for U.S.-listed IPOs Since 2000. Giri Cherukuri, head trader at OakBrook Investments, says that the trend is not only reducing the number of companies an investor can own in the small cap space, it’s also redistributing wealth that would previously have gone to public shareholders to private equity and venture capital firms. “By the time a company comes to market it’s already a mid-cap company, so some of those returns that come to small cap investors kind of disappear,” he said. In essence, many of the best small companies aren’t becoming small-cap stocks.

Small-cap comeback?

Some investors, however, are not convinced and are betting on a revival in small caps. They argue that the recently signed tax reform legislation and deregulation from the Trump administration have created an environment where small-cap stocks are poised to outperform large companies. Amy Kong, senior portfolio manager and managing director at Fiduciary Trust, says that she is increasing her small-cap exposure. She argues that the combination of tax reform and deregulation will benefit to small cap stocks disproportionately. “Small caps do the vast majority of their business within the United States, so they will likely benefit more than a typical multi-national, large cap [company] from lower tax rates,” Kong said. The tax reform’s provision that U.S. companies bring money held overseas back to the country could also benefit smaller companies’ stock because larger companies will look to use that money buy them – increasing the smaller company’s stock price, Kong said. But even that trend is benefitting big companies like Facebook and Amazon, MFS’s Weisman argues, which will continue to gobble up market share and end up owning the companies that would otherwise have threatened them with new technological developments. That means investors would be wise to rollback their exposure to small caps and add to their holdings of the market’s big names, like Facebook, Apple, Alphabet, Baidu, Alibaba and Tencent. “You consider these companies that are winning and in spite of the fact that they seem rich you go more overweight these large companies because that’s a way to add alpha,” Weisman said. “It’s almost diametrically opposed to how we would have thought about alpha in the past.” —

Dion Rabouin is a markets reporter for Yahoo Finance. Follow him on Twitter: @DionRabouin.

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