Investors are waiting with bated breath for small caps to turn around this year and cash in on the newly signed tax cuts. So, it is quite likely that they will be eager to know which theme to pick now — growth, value or blend.
The tax bill cuts “the corporate rate from 35% to 21%, gives pass-through businesses like the Trump Organization a 20% tax deduction, raises the standard deduction, expands the child tax credit, and temporarily lowers individual rates across the board.”
Now, sincesmall-caps have a higher median tax rate, corporate tax cuts should give big-time benefits to these stocks. Plus, consumers may save on tax payments which will result in higher tax savings and benefit small-cap stocks (read: Tax Bill: What ETF Investors Need to Know).
However, there are some drawbacks. The benefit of lower tax rates is likely to be outweighed by pricey valuations, chances of higher volatility and tighter credit conditions, by some analysts (read: Tax Reform: A Boon or Bane for Small-Cap ETFs?).
Against this backdrop, below we detail why small-cap value ETFs will do better than the growth ones this year.
As per Bloomberg,small-cap value is highly reliant on domestic growth as 80% of its market cap is concentrated on cyclical sectors such as industrials, discretionary and information technology (read: 3 Sector ETFs for 2018).
Since higher domestic consumption will likely drive the performance of small caps in 2018, it is better for investors to look at value stocks over growth. Bloomberg also indicated that specialty retail makes up about one-third of the small-cap value discretionary sector and has beaten even large-cap counterpart since mid-August.
Need for Value Quotient
According to Bank of America Merrill Lynch, small caps normally lag at the end of bull markets. Small-cap stocks had an average negative alpha of 6% in the last six months of the past four bull markets.
Also, as per an article published on the street.com, the previous tax law entailed full deduction of interest paid. The new law will hold companies back from relying on debt too much. There is a provision in the tax blueprint that calls for limiting “deductions to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years, and 30% of EBIT after that.” Since many small-cap stocks are debt-reliant for their survival, the new rule may cut back the full benefits expected from the tax reform.
Plus, volatility last year was at record-low levels and may spike this year. Since small-cap stocks underperform in a volatile market, it is better to tap the value spectrum of this capitalization.
Better Earnings Growth
Small-cap value stocks have also seen earnings estimates being risen by 6.5% against a decrease of 6.3% for growth companies. Probably this is why small-cap value stocks have beaten out small-cap growth since mid-August.
Under the ETF Performance
Below we highlight the better performances of some value ETFs like First Trust Small Cap Value AlphaDEX Fund (FYT - Free Report) (12.3%), WisdomTree US SmallCap Earnings ETF (EES - Free Report) (up 13.8%), Vanguard S&P Small-Cap 600 Value ETF (VIOV - Free Report) (up 12.9%) and Schwab Fundamental U.S. Small Company Index ETF (FNDA - Free Report) (up 11.4%) than growth ETFs including Vanguard Small Cap Growth ETF (VBK - Free Report) (up 11.2%) and Guggenheim S&P 600 SmallCap Pure Growth (RZG - Free Report) (up 10.6%) since September 2017.
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