Last year, investing in big U.S. stocks would have earned you the best returns, but this year might be different. Big company earnings are being challenged by the strong dollar, and that may give the edge in 2015 to small stocks.
First of all, what do we mean by “small stocks”? When we say “small cap” stocks, we don’t mean small like the corner hardware store. The average small cap stock is worth a steep $1.9 billion. But that’s smaller than the average large-cap stock in the S&P 500, worth over $38 billion. Examples of well-known small-cap companies include Office Depot, 1-800 Flowers.com, Ultimate Software, Bankrate, Trulia, and Vail Resorts.
What’s the problem with big company stocks? Big U.S. multinational companies are being hurt by the rising dollar. “A stronger U.S. dollar has hit many larger companies with big international operations by diminishing the value of revenue earned abroad,” reports Dan Strumpf and Corrie Driebusch for The Wall Street Journal. That’s a headwind many large companies might find hard to overcome.
When big, multinational companies like Microsoft or IBM earn money overseas, they need to “translate” it back into dollars to report it on their U.S. financial statements. When the U.S. dollar is strong, like it is now, their overseas earnings shrink in dollar terms, even if they earned the same amount as always in Euros or other foreign currencies. That makes their earnings look weak, and in turn may negatively affect their stock value.
How is it that small companies are escaping the “strong dollar” curse? Small companies focus less on foreign sales than most big companies. “These stocks are closely tied to the U.S. economy and generate most of their revenues from the domestic market, making them safer bets during global turmoil than their large and mid cap counterparts,” say analysts at Zacks Investment Research.
In fact, research does show that small-cap companies derive only 19% of their sales overseas, on average, while mid-cap companies book 27% of their sales outside the U.S., and big cap companies do 35%, on average.
Why should you have small company stocks in your portfolio? Small stocks are a normal part of a well-diversified portfolio. Small-caps struggled in 2014, but the tide may now be turning, since small-caps could find their footing in today’s environment of solid U.S. domestic growth, an optimistic consumer, and a strong dollar. Now’s a good time to give small cap stocks a second look.