Worried About Large-Cap Losses? Think Small

February got off to a dismal start, with dizzying declines during the first two weeks that shaved 12% of value off the Dow Jones Industrial Average and the S&P 500.

The correction underscored the danger of investing in momentum stocks that are overvalued based on unrealistic earnings assumptions. These brand-name stocks are stars among TV yakkers. But their share prices are benefiting from Polyannish assumptions about their ability to grow earnings.

In what’s shaping up to be a crazy year ahead, small-cap companies could bring sanity to your portfolio.

These “small fry” are positioned to outperform their larger brethren and provide not only adrenaline but also ballast to an economy that’s headed for uncharted waters.

Typically, small caps are considered riskier. However, bull runs often are propelled by a coterie of strong stocks that are “market leaders.” When these stocks begin to falter, it usually means that the rest of the troops will follow. We’ve seen this dynamic in recent weeks.

Meanwhile, policymakers in Washington, DC have embarked on an experiment that violates economic orthodoxy. Uncle Sam is applying massive stimulus in the late stage of a recovery. That makes overvalued large caps, especially those that have led the bull market in recent months, vulnerable to inflation and rising interest rates.

Value is back…

In this dicey environment, the virtues of “value” have come to the fore.

Small businesses represent more than 99.7% of all U.S. employers. They employ half of all private sector workers. They account for up to 80% of the new jobs created annually in the country.

Every portfolio should have exposure to small caps. The beginning of 2018 is a good time to start.

The term “small cap” is fungible. It’s typically defined as a market valuation of between $300 million and $2 billion. It’s a truism that small companies form the heart of the country’s job creation. They also generate breakthrough technologies.

Many analysts contend that the correction isn’t over. I happen to agree. Mega-cap market leaders are poised to become laggards. Inflated expectations will catch up with them. Conversely, several tailwinds position small stocks as safer havens for investors.

Let’s start with President Donald Trump’s policies, which are of surprising benefit for smaller companies.

Profitable firms in the Russell 2000 tend to pay higher taxes than global behemoths. The big boys are adept at lowering their rates through expensive lobbyists and accountants; they also avoid taxes by squirreling their profits overseas.

The tax overhaul bill that Trump signed in December slashes the top corporate rate to a flat 21% from the highest 35% rate. Lowering the corporate tax rate will boost the bottom lines of many companies, which benefits shareholders.

The new law includes numerous changes to the taxation of income from pass-through entities such as S corporations, limited-liability corporations and partnerships. In general, the new law allows businesses to exclude 20% of their net income from taxation, subject to certain limitations.

The deduction could also be limited or disallowed for specified service trades—such as lawyers, doctors and accountants—based on an income threshold.

Overall the changes to the taxation of pass-through entities will be beneficial to many small business owners. That’s a big shot in the arm for the country’s innovators.

Another future advantage for small companies is the likelihood that Trump’s laissez-faire cabinet members and agency heads will lessen regulations against the financial services sector. That in turn will make it easier for regional banks to give loans to small companies.

Trump’s “America First” protectionist policies, which pose a threat to expert-dependent giants, would actually benefit small caps. The majority of small caps derive the bulk of their sales domestically, which means that trade wars and a strong U.S. dollar tend to hurt them less.

Letters to the Editor

“How do health care stocks look in 2018?” — Gerald R.

Pharmaceutical and health care stocks offer a solid investment proposition: robust dividends, double-digit capital appreciation, and defensive stability. These characteristics will only get stronger in 2018, as demographics, tax law, and government policy provide tailwinds.

America’s major health care companies are engaged in a flurry of merger and acquisition activity. This activity will accelerate in 2018 as the tax overhaul signed in December pumps cash into the coffers of corporations.

Questions about opportunities in the health care sector? Send me an email: mailbag@investingdaily.com

John Persinos is managing editor of Personal Finance and chief investment strategist of Breakthrough Tech Profits.