Why U.S. small caps may lag despite U.S.-China trade truce

Encore Wire

02/07/2019 06:00

(Repeats story first published on Monday)
    By David Randall
    NEW YORK, July 1 (Reuters) - A truce in the trade war
between the United States and China that pushed large-cap stocks
to new record highs Monday does not appear to be enough to buoy
the shares of small U.S. companies that are struggling under the
weight of higher tariff costs. 
    Lower margins and less pricing power are preventing small
companies from either passing on or weathering the effects of
higher trade tariffs to the same degree as large caps,
effectively putting a ceiling on their growth prospects, fund
managers and analysts say. 
    That is souring investors on their shares and leaving
small-caps underperforming in a steep reversal from last year,
when many investors jumped into small companies in the
expectation that they would be insulated from the trade wars
because of their focus on the domestic market. 
    For the year to date, the benchmark Russell 2000 index of
small companies is up nearly 17%, yet remains more than 8% below
the record highs it reached in August 2018. The large-cap S&P
500, by comparison, hit record highs Monday as part of its
nearly 18.5% rally this year.   
    “I would not be overweight in small caps right now because
the risks are too high relative to large caps,” said Barry
James, a portfolio manager at James Advantage Funds whose James
Micro Cap fund is one of the top-performing small-cap funds for
the year to date. "That's eventually going to change and they
could have a spectacular run, but this year at least the index
overall is not attractive from a risk standpoint."
    The Russell 2000 index is dominated by financial and
healthcare, two sectors that face the risk of compressed margins
from lower interest rates and increased governmental regulation
if Republicans lose either the presidency or the Senate in the
2020 elections, James said. 
    As a result, James is focusing on companies like
recreational products maker Johnson Outdoors Inc  JOUT.O  and
electric wire maker Encore Wire Corp  WIRE.O  that have
above-average growth prospects, he said. 
    The United States and China agreed on Saturday to resume
trade negotiations after U.S. President Donald Trump offered
concessions to his Chinese counterpart Xi Jinping when the two
met at the sidelines of the Group of 20 summit in Japan.
    Those included no new tariffs and an easing of restrictions
on tech company Huawei Technologies Co Ltd  HWT.UL . China
agreed to make unspecified new purchases of U.S. farm products
and return to the negotiating table.  urn:newsml:reuters.com:*:nL4N2400C0
    Dan Mahr, a portfolio manager of the Federated MDT All Cap
Core fund, said that his fund remains underweight small caps in
favor of larger companies like MasterCard Inc  MA.N  and Charter
Communications Inc  CHTR.O  that are benefiting more from market
momentum. 
    "Investor sentiment is much higher as you go up the
cap-scale," he said. 

    WEAKENING GLOBAL ECONOMY 
    A weak global economy is also weighing disproportionately on
small-cap stocks, which are saddled with rising international
revenues and feel a greater hit from trade tariffs than large
caps, said Venu Krishna, deputy head of U.S. equity research at
Barclays. 
    "The core issue is that global growth is slowing and while
the trade war concerns ebb and flow there's a general sense that
they are here for longer," he said. "We don't see a catalyst
that will push small-caps higher." 
    Barclay's now estimates that small-caps will post EBITDA
(earnings before interest, tax, depreciation and amortization)
growth of 2% this year, down from its estimate of 5.5% growth
earlier this year, Krishna said. 
    Those economic concerns are pushing investors to pile into
companies that seem to be flawless and punish those that might
miss analyst estimates or have additional leverage on their
balance sheets, said Randy Gwirtzman, a portfolio manager of the
Baron Discovery fund. 
    "If it's not perfect, it's not working right now," he said. 
    As a result, Gwirtzman has been moving into biotech
companies Revance Therapeutics Inc  RVNC.O  and Esperion
Therapeutics Inc  ESPR.O  that have been hurt by investor
skittishness over the healthcare sector. At the same time, he
has been adding to his position in cyber security company
ForeScout Technologies Inc  FSCT.O , whose shares tumbled in May
after its guidance fell short of Wall Street expectations. 
    "There are many quality companies that for whatever reason
people are just scared of," Gwirtzman said. "People are running
to things that have no problems in them and paying a lot, and
we'd rather get things with manageable problems at much lower
multiples."

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Trump says China trade talks 'back on track,' new tariffs on
hold     urn:newsml:reuters.com:*:nL4N2400C0
EXPLAINER-How U.S.-China talks differ from any other trade
negotiations      urn:newsml:reuters.com:*:nL2N23Z174
    ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>
 (Reporting by David Randall; Editing by Jennifer Ablan and Lisa
Shumaker)
 ((David.Randall@thomsonreuters.com; 646-223-6607; Reuters
Messaging: david.randall.thomsonreuters.com@reuters.net))