The Russell 2000 hit new highs last week as small companies continue to post earnings growth that surpasses larger capitalized companies that comprise the S&P 500 index.
After a historical and unbroken decade of consistent growth, the larger indexes remain stuck in correction territory, while smaller companies, as reflected in the steadily rising Russell 2000, are entering a phase of sustained growth.
While large stocks have led the market over the past 12 months, recent gains have been posted by the smaller indexes comprised of small-cap companies. Through March, the Russell has gained 8%, compared to the 1.5% gain of the Dow Jones Industrial Average and a 3% rise in the S&P 500.
Although the Russell 2000 gave up some of the gains it posted immediately after the election and implementation of the tax cuts, small-cap businesses have continued to post solid earnings growth during that period even though investors shifted, until recently, into larger-cap funds.
There are a number of factors responsible for creating the conditions that have made increased growth for the small caps possible. Two of the most prominent have been tax cuts and a lifting of the regulatory burden on small companies.
The positive effect on earnings in an environment where onerous and costly regulations have been pared back cannot be underestimated. It is no secret that larger-cap companies can absorb the regulatory cost component of doing business better than their thinly or smaller capitalized counterparts. For some smaller businesses with thin operating margins, the costs of regulation have a disproportionate impact on their ability to remain profitable. That is the reason those who protested most vigorously the implementation of Obamacare were smaller enterprises, as the costs would have a disproportionately negative impact on their earnings, relative to S&P 500 companies.
In order to gain some appreciation of the costs of complying with multifarious regulations, consider that according to the House Small Business Committee chairman, smaller capitalized firms spend, on average, $12,000 per employee per year, sifting through thousands of pages of labyrinthine regulations and battling intransigent bureaucrats. Before a small business can even open its door, it must spend approximately $83,000 in start-up costs directly related to regulations.
By comparison, S&P 500 companies have an army of large accounting firms, tax lawyers and large and well-connected Washington law firms with attorneys dedicated to interpreting and implementing regulations in a manner least intrusive and least costly for their corporate clients. Large corporations can also challenge agency rulings they feel are unduly burdensome or they can argue, through their attorneys, that they have “substantially complied” with the pertinent provisions.
Most small-cap companies don’t have these resources available, which is one of the reasons regulatory burdens have a disparate impact on the Russell 2000 corporations.
An additional reason compliance with government regulations exerts an asymmetrical liability on smaller capitalized businesses is because the fixed costs of adhering to regulatory provisions can be spread out over a greater revenue base in large companies than in small ones.
Promulgating additional regulations creates uncertainty, which keeps small business owners from investing and hiring. Because few business owners can predict the scope or impact of new regulations, they often delay buying capital equipment or adding workers as they wait to see the impact of the new regulation(s).
A loosening of the cumbersome and costly regulatory burden by the Trump administration has now levelled the playing field between the two business sectors.
Changes to the tax laws clearly have enhanced the prospective profitability of smaller companies, who tend to pay a higher effective tax rate than larger multinationals. The boost from a reduction in corporate tax rates has provided additional funds for expansion. Again, the benefits form the tax reductions have been more pronounced for the Russell 2000 companies, as evidenced by the surge in the index.
It should come as no surprise, then, that the upward trajectory of the Russell 2000, despite a brief downturn for the past year, has occurred in tandem with a relaxation of the regulatory burden by the Trump administration.
The influence of one factor, often overlooked, that contributed to the steadily climbing earnings growth of the S&P 500 companies was the astounding amount of cash expended on share buybacks. This strategy tended to mask the fact revenue growth in the large-cap sector was somewhat underwhelming.
Due to the propitious conditions that currently prevail, the small-cap sector is now poised to show accelerated earnings growth. Another advantage smaller-cap businesses enjoy is that they do not have the foreign currency translation exposure the larger multinational corporations do.
Both the reduction in tax rates and rescission of stifling regulations clearly have helped the Russell 2000 corporations and the benefits for the bottom line, compared to S&P 500 companies, have been markedly disproportional.
Disclosure: I have no positions in any of the securities referenced in this article
