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Why small caps could see big gain in the Trump tax plan

small-cap stocks
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The biggest taxpayers in American business today are the smallest companies, and they could see a Trump windfall that is now a big part of their appeal with investors.

"The effective tax rate for the Russell 2000 is 32 percent, and the S&P 500 we calculate at 26 percent. There's three reasons they rallied so hard — valuation, the domestic exposure and the corporate tax rate," said Lori Calvasina, chief U.S. equity strategist at Credit Suisse.

Calvasina said the recent run in small caps has made them pricey. They are still attractive, she said, but getting close to the point where she would consider turning neutral on them. This week, the small-cap Russell 2000 has given back some gains — about 1.4 percent — after a 15-day winning streak boosted it by 16 percent. The Russell was up 11 percent for November.

"Lowering the corporate tax rate is the number one issue we've been talking to investors about regarding the Trump administration. Investors think there's good will in Congress," Calvasina said. Small caps are also appealing because President-elect Donald Trump campaigned on a tougher global trade stance, which would affect large companies with overseas profits more than small companies without them.

Trump has proposed lowering the corporate tax rate to 15 percent from 35 percent, but even if there's a compromise to 25 percent, most companies still benefit. Small caps are subject to higher tax rates because they are more domestically focused, and large companies have been squirreling foreign profits away overseas. Trump says he will offer those companies a tax holiday to repatriate their international earnings.

Jefferies equity strategist Steve DeSanctis said the five-year average tax rate for small caps stands at 33.5 percent, versus 30.1 percent for large-cap companies, based on companies in the S&P 600 small-cap index and the S&P 500 large caps. Telecom has the highest tax rate, followed by consumer staples, utilities and discretionary. Tech and financials are among the lowest.

"If tax rates are reduced to 22 percent, we see a significant boost to earnings (that lowers) the P/E to 16.2X, which is still above the average. However, using a 15 percent tax rate, we see that earnings jump to $88.71 and the P/E falls below 15X," DeSanctis wrote.

DeSanctis said based on history, however, the small-cap world didn't see a big bump in stock prices. There have been six tax cuts since the end of World War II, and in the years before the cuts, small caps were higher half the time. But in terms of return, they lagged by an average 1 percent. In the actual year of the cut, small caps lagged large caps by an even wider margin of 1.9 percent and beat large caps just twice.

"In the following year, overall absolute performance is below average, but small ekes out a win versus large," he wrote in a note.

The case for an earnings pop, however, is clear. The U.S. has the highest corporate tax rate in the G-20, with Russia, the U.K., Turkey and Saudi Arabia the lowest at 20 percent, according to Jefferies.

Before rallying in November, small caps were in a rough patch. Barclays noted that the small cap return of -4.8 percent in October was the worst since January and lagged large caps by -2 percent, the largest margin in over a year.