Do Tariffs Impact Small Caps?

Jun. 09, 2019 11:30 AM ETVB, SCHA, FYX, ISCB, SMLF, FLQS, PBSM


  • Conventional wisdom would argue that small-cap stocks tend to be immune from tariffs because of their domestic focus - a view with which we do not agree.
  • The reason: Tariffs tend to increase input costs across global supply chains, which in turn can hurt demand (through price increases) or curtail profit margins.
  • To mitigate these potential risks, we believe investors should focus on companies with strong balance sheets and attractive valuations, as these firms may be better able to weather trade-related risks.

By Craig Kempler, CFA

Small caps tend to earn a majority of their revenues domestically. Still, that may not insulate the stocks from tariffs, says Craig Kempler, Portfolio Manager at Perkins Investment Management. Here's what investors can do.

There is much debate on the impact of tariffs on small-cap companies. When the prospect of new or rising tariffs first arose, many investors took the view that small-cap companies would be immune because of their domestic focus. We did not share this view then, and do not now.

Tariffs typically manifest themselves at the company level in two main ways: First, from a demand standpoint, an increase in tariffs generally represents an increase in prices. When prices rise, demand falls and growth rates decelerate. Second, when companies are unable to pass on a full price increase, they have to absorb a portion of the tariff, reducing earnings power and profit margins.

While we believe the United States can weather the trade storm better than most countries, an increase in tariffs across a range of goods globally would be negative for growth rates and equity valuations broadly. Tariffs may benefit the companies that the tax is intended to protect, but the number of firms negatively impacted usually far outweighs the number seeing any benefit.

The Impact to Small Caps

When it comes to small caps, we think the companies most at risk, from a profit margin standpoint, are consumer discretionary, technology and certain industrials firms. In the case of consumer discretionary and technology, many parts of these sectors' supply chains run through Asia and China. Higher tariffs on Chinese goods have the potential to decrease the profit margins of suppliers, as they may be unable to fully offset the tariff increase with price increases. For many industrial companies, their supply chains also run through Asia/China, with significant exposure to Mexico, as well. As such, firms such as heavy machinery and auto manufacturers could have to fight margin compression should global tariffs increase.

Other challenges also exist. In consumer discretionary and technology, multiples remain elevated, making it difficult to find higher-quality names trading at reasonable valuations. Many industrials are tied to the economic cycle; finding firms with secular growth drivers could be critical in a rising tariff environment. Even companies with mostly domestic revenues could carry some risk. UniFirst (UNF), a maker of workplace uniforms, is one example. The company earns nearly 100% of sales domestically but manufactures a portion of its garments in Mexico.

Stay Focused on Valuation, Balance Sheets

As such, in today's environment, we believe it is especially important for investors to focus on company balance sheets and valuation. In addition, some sectors, such as consumer staples, may be more insulated from tariff wars since demand for basics such as food and household products is likely to persist regardless. (The sector could also eventually benefit from an improved trade deal with China, should one be reached).

In the meantime, we fully expect to see continued volatility from the potential of rising tariffs. Historically, periods of volatility have presented opportunities to invest in high-quality companies trading at attractive reward-to-risk ratios. We think investors should be ready to take advantage of these temporary dislocations, when and if they appear.

Disclaimer: Please consider the charges, risks, expenses and investment objectives carefully before investing. Please see a prospectus or, if available, a summary prospectus containing this and other information. Read it carefully before you invest or send money.

The opinions and views expressed are as of the date published and are subject to change without notice. They are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. No forecasts can be guaranteed. Opinions and examples are meant as an illustration of broader themes and are not an indication of trading intent. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. Janus Henderson Group plc through its subsidiaries may manage investment products with a financial interest in securities mentioned herein and any comments should not be construed as a reflection on the past or future profitability. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.

Janus Henderson Investors ©2019

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Janus Henderson Investors exists to help clients achieve their long-term financial goals. Formed in 2017 from the merger between Janus Capital Group and Henderson Global Investors, we are committed to adding value through active management. For us, active is more than our investment approach – it is the way we translate ideas into action, how we communicate our views and the partnerships we build in order to create the best outcomes for clients. While our investment managers have the flexibility to follow approaches best suited to their areas of expertise, overall our people come together as a team. This is reflected in our Knowledge. Shared ethos, which informs the dialogue across the business and drives our commitment to empowering clients to make better investment and business

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