Small-capitalization stocks and related exchange traded funds could outperform as the new tax reform bill takes effect.
Salvatore J. Bruno, hief Investment Officer and Managing Director at IndexIQ, in a research note, argued that small-cap stocks could enjoy three significant benefits from the passage of the Tax Cuts and Jobs Act of 2017, including a lower tax rate, greater tax relief compared to larger companies and ability to capitalize on a faster growing domestic economy.
Specifically, smaller companies have historically paid a higher effective tax rate partly because they can not shield earnings abroad in lower tax jurisdictions. The median effective tax rate for the Russell 2000 companies was 31.9%, compared to the 28% for those in the large-cap S&P 500.
Small-cap companies are also domestically focused, with the average Russell 2000 company only generating about 20% of revenue for overseas sources, compared to S&P 500 companies that generate over 40% of revenue from abroad in 2016. Consequently, a greater percentage of these small-cap companies’ revenues and earnings will be taxed at the lowered 21% rate.
Lastly, small companies typically benefit from a faster economic expansion, which may occur under a more lax tax scheme. Furthermore, small-caps are great targets for mergers and acquisitions in an growing economic environment.
ETF investors who are interested in capturing the potential growth opportunity of small-caps can look to something like the IQ Chaikin U.S. Small Cap ETF (NasdaqGM: CSML), which tries to reflect the performance of the Nasdaq Chaikin Power US Small Cap Index.
The underlying index applies a shareholder yield screen and the so-called Chaikin Power Gauge, a quantitative multi-factor model that tries to identify securities that are expected to outperform their peers, to select components from the Nasdaq US 1500 Index.
The Chaikin Power Gauge is a 20 multi-factor model that screens for value, growth, technical and sentiment factors, such as price-to-book value, return-on-equity, free cash flow, price trends, relative strength, volume trend, earnings growth, earnings trends, projected price/earnings ratio, insider activity, short interest and earnings estimate trends. The gauge will identify each security’s ability to outperform market-weighted products and active strategies.
For more information on small-capitalization stocks, visit our small-cap category.