As strong dollar weighs, not all small US stocks are beautiful

Hennessy Advisors

22/04/2015 12:00

(Repeats with no changes to text) 
    By Chuck Mikolajczak 
    NEW YORK, April 22 (Reuters) - As the dollar's rally gained 
pace since the start of the year, shares of small companies 
followed, bid up by investors betting that such firms will be 
largely spared currency headwinds faced by big multinationals. 
    Now, however, after investors have flung billions of dollars 
into small stocks and small stock mutual funds over the past  
several months, the "small is beautiful" strategy's shortcomings 
are becoming apparent.  
    First, the rally made many of the members of the small cap 
Russell 2000  .RUT  index expensive. Secondly, not all small 
firms offer the high degree of immunity from the strong dollar's 
negative effect on U.S. exporters that investors expect.  
    "It's very simple to say small cap is domestically focused, 
they are going to hold up better than large cap because of the 
currency," says Bank of America Merrill Lynch small-cap 
strategist Steven DeSanctis. "That is not always the case."  
    Some small firms generate as much of their sales overseas as 
their bigger rivals and might be even more exposed than large 
corporations that have hedging programs and operations spread 
across multiple markets to cushion the impact. 
    Other act as suppliers to big players that suffer from the 
dollar rally or compete against imports that have become 
cheaper.  
    Some may simply face other headwinds such as energy 
companies hurt by the slide in crude prices.  
    In fact, during the previous spell of dollar strength from 
1995 to 2002 small stocks underperformed large caps by 4.8 
percent as investors, rattled by the Asian currency crisis, 
chose more liquid and less volatile assets, according to an 
analysis by DeSanctis. 
    If the Federal Reserve sparks another flight to safety with 
an interest rate hike, small stocks could again suffer, 
especially given their already high valuations, DeSanctis said. 
    Russell 2000 stocks now trade at 24.4 times earnings 
compared with 17.1 for the large cap S&P 500  .SPX , according 
to Thomson Reuters data.  
 
    LOSERS AMONG WINNERS 
    So far in 2015, the dollar has risen 8.3 percent and the 
Russell 2000 - made up of companies with less than $4 billion in 
market capitalization - has rallied 5 percent, more than double 
the 1.8 percent increase in the S&P 500. 
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 Graphic:small stocks and the dollar: 
 http://link.reuters.com/ten54w)  
     
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    In March, retail investors put $1.7 billion into small cap 
mutual funds and exchange traded funds, while they pulled $11.9 
billion out of large cap funds, according to Thomson Reuters 
data. 
    But those who invested in small cap energy sector  .SPSMCE , 
for example, are looking at a loss of more than 44 percent since 
the start of July, when crude prices began heading lower, the 
dollar's strength playing a part in the slide. 
    Examples of companies that rely on overseas markets also 
underscore the need for caution. 
    Helicopter manufacturer Erickson Inc  EAC.O , which 
generated more than 60 percent of its 2014 revenue outside of 
North America and depends on the oil industry for a big chunk of 
its business, has seen its shares tumble 45 percent so far this 
year. 
    Weight Watchers  WTW.N , which derives over 40 percent of 
its business from overseas, has said it expects the strong 
dollar to shave roughly 15 cents a share off of its projected 
annual 2015 earnings of 40-70 cents a share. Its share price is 
down nearly 70 percent for 2015 and the company has acknowledged 
the growing challenge from mobile calorie counting applications. 
    Yet other more domestically-focused weight management peers 
have fared better. Nutrisystem Inc  NTRI.O  shares have held 
steady over the same period while Medifast Inc  MED.N  has 
slipped 7.8 percent.  
    A spokeswoman for Weight Watchers declined to comment for 
the story and representatives for Erickson were unavailable to 
comment. 
    To be sure, several small companies are insulated from the 
dollar effect and doing fine. 
    For example, Drew Industries  DW.N , a maker of components 
for recreational vehicles and manufactured homes, reported an 
almost 29 percent year-on-year rise in fourth quarter sales. Its 
shares are up more than 20 percent since the start of the year 
yet its forward price-earnings ratio of 18.3 is still well below 
that for the whole small-cap index.  
    "We are trying to focus on companies that are much more 
domestic oriented," says Michael Corbett, chief investment 
officer at Perritt Capital Management in Chicago. Among his 
picks are several financial services companies, such as Hennessy 
Advisors  HNNA.O , Silvercrest Asset Management  SAMG.O  and 
Liberty Tax  TAX.O . 
    But even those who cherry-pick such companies have to be 
aware that they are arriving late to the party.  
    For example, Texas Roadhouse  TXRH.O  is a U.S.-focused 
restaurant chain, but its forward price-to-earnings ratio is 
near its eight-year peak just below 25.  
     "I wouldn't say that it shouldn't (go higher) or can't," 
says Edward Hemmelgarn, chief investment officer of Shaker 
Investments in Cleveland, Ohio.  
    "But the price has moved up faster than the earnings have." 
 
 (Reporting by Chuck Mikolajczak; Editing by Linda Stern and 
Tomasz Janowski) 
 ((charles.mikolajczak@thomsonreuters.com; @ChuckMik; +1 646 223 
5234; Reuters Messaging: 
charles.mikolajczak.thomsonreuters.com@reuters.net)) 
 
Keywords: STOCKS SMALLCAP/DOLLAR