Small-cap stocks could outperform their large-cap counterparts the rest of this year if President Donald Trump increases his protectionist stance on trade and other matters.
They also have further potential upside relative to large stocks from the lower corporate tax rate.
The Russell 2000 — which is made up of small-cap stocks — is up nearly 5 percent through Wednesday's close after Trump announced he wanted to implement tariffs on steel and aluminum imports. Meanwhile, the large-cap S&P 500 index is up just 1.3 percent in that time.
The tariffs and possible retaliation from countries such as China put at risk large-cap companies that do lots of business overseas. Small-cap companies, meanwhile, are less exposed to a trade war, given most of their business is domestic.
"The protectionist agenda will be better for small-caps relative to large-caps," said Dan Miller, director of equities at GW&K Investment Management. "I would recommend investors buy into small-caps. It's a good time to get into those names."
Trump made the tariffs announcement on March 1 and a week later signed two proclamations levying a 25 percent charge on steel imports and a 10 percent tariff on aluminum imports. Mexico and Canada — two key U.S. trading partners — were exempt from the tariffs.
Reuters also reported Tuesday that Trump may impose tariffs on $60 billion of Chinese goods. Investors worry that other countries could retaliate by implementing their own tariffs on U.S.-made goods and sparking a trade war.
"Small-caps have a much smaller revenue coming from overseas, so they are much less affected by tariffs than the multinationals," said Sean O'Hara, president of Pacer ETFs.
Companies in the Russell 2000 derive 21 percent of their sales from overseas, on average, while the large-cap S&P 500 obtains 30 percent from outside the U.S., according to data from Bank of America Merrill Lynch.
Trump's shift toward more protectionist policies has caused turmoil in the White House. Gary Cohn resigned as National Economic Council director after disagreeing with the president on tariffs. The New York Times also reported that some of Trump's top staffers were unaware the tariffs announcement was coming.
Trump also touted the tariffs at a rally in Pennsylvania prior to a special election. "A lot of steel mills are now opening up because what I did," he said Saturday. "Steel is back, and aluminum is back."
A more protectionist White House could also bring a shift in market leadership. Boeing — a massive multinational — is by far the best-performing stock in the Dow Jones industrial average over the past 12 months. In that time period, the aerospace giant is up nearly 85 percent. But Boeing has declined 8.8 percent this month. Meanwhile, New York Mortgage Trust — a small-cap stock with a market value of $670 million — is up 8.8 percent in March.
Investors and strategists also noted that small-caps have other factors playing in their favor.
The group is also more likely to benefit more from lower corporate taxes than large-caps given a larger share of their business is U.S.-based. Trump signed a bill in December that slashed the U.S. corporate tax rate to 21 percent from 35 percent.
Corporate earnings have also been strong for small-caps, rising 12.8 percent on a year-over-year basis for the fourth quarter, according to Steven DeSanctis, equity strategist at Jefferies.
However, DeSanctis said small-caps could be in just as much trouble as large-caps if the U.S. engages in a global trade war.
"You've got to remember, a lot of these companies service the large-cap companies that have business overseas," he said. "For example, if Boeing is impacted by tariffs, then the companies that sell parts to Boeing will get crushed."
He also noted that small-caps declined sharply in the summer of 1998, which followed the Asian financial crisis. "A lot of people were saying small-caps would outperform because of the slowdown in Asia. That was one of the worst three-month periods for small-caps."
And there is also the possibility that the tariffs implemented by Trump are just a tool to negotiate better trade deals, meaning they may not be as strong as investors fear.
"This is very much in keeping with the way this White House goes through policy," said Scott Clemons, chief investment strategist at Brown Brothers Harriman. "The unanticipated statement [March 1] is the beginning of the negotiations, not the ending. I think the market has gotten used to this."
Still, O'Hara of PacerETFs said small-caps could go up regardless of the degree of Trump's shift because they have attractive valuations compared with large-caps. "Small caps have largely underperformed large-caps over the past years. So there's a bit of a regression to the mean there," he said.
The S&P 500 is up nearly 34 percent over the past three years, while the Russell 2000 has gained 28.6 percent in that time period.