Standard Life Investments

Global Outlook

US Smaller Companies - Bigger is not always better

Ongoing economic strength and tax reform are fuelling corporate profits in the US for companies large and small. Meanwhile, wage growth and rising input costs are putting pressure on margins.

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Bigger is not always better

One of the central strands of the tax reform package that recently made its way through the US Congress is a lowering of the corporate tax rate from 35% to 21%. US small-cap companies stand to benefit more than larger ones from this reduction given a higher proportion of their revenues and earnings are generated domestically when compared to big multi-nationals. Consequently, small-caps will see some of the largest reductions in ongoing tax rates. Accelerating GDP growth tends to favour them as well. Consequently, we expect profits growth of as much as 20% net of tax in 2018 for US smaller companies, with non-tax affected operating income rising by about 8% (see Table 1).

Good things come in small packages

However, it is important to note that the broad-based benefit of low inflation appears to be coming to an end. This bolstered corporate margins over the past decade, pushing them through 2007 peak levels, but now looks set to fade given wage growth is starting to accelerate and raw material prices started 2018 at much higher levels than in 2017.

Pricing power rules

We look for companies that can pass along input cost hikes; pricing power as a theme should be more important in coming years. A key characteristic of such companies is that their customers cannot do without them. Take Lippert Components Inc (LCI) as an example. LCI manufactures components and after-market parts for trailers and RVs, and acts as a distributor for some specialized RV and marine products. As one of the largest component makers for the industry, its share of dollar content per new RV has risen every year of this century. LCI is indispensable to its customers.

Based in a small town in Indiana where the labour market is extremely tight, LCI is experiencing wage pressures as it tries to service 15+% volume growth from customers. While LCI is vital to the ability of its customers to make and sell products, the original equipment manufacturers (OEM) who are the customers raise prices only infrequently during a model year. Historically, OEMs have taken up to five months to acknowledge and be willing to pay for input cost shifts that start suddenly. As a result, LCI’s margins are under pressure from both wage and input cost hikes – for now. That leads to some volatility in margins as prices rise, but not to permanent margin compression.

While the path may not be a straight one, we believe LCI should shortly be able to push pricing and margins higher, allowing earnings to rise on much higher revenue. In addition, LCI’s tax benefits will partly fund higher wages and materials costs, helping to create more stable net margins for a company that has increased its reach over the past decade. Despite short-term challenges, LCI’s story is attractive partly because of the significant improvement in its customers’ end markets. RVs are becoming popular with younger people and the industry forecasts growth well in excess of automobile growth for the next few years.

Nursing wages and margins higher

Another example is AMN Healthcare, a temporary staffing company supplying nurses into a market struggling with a dearth of qualified staff. Given the shortage of nurses, temporary staffing services have become important providers of flexible labour. We like AMN Healthcare’s much more direct approach to dealing with wage inflation and it has been able to pass wage hikes for temporary workers through to end customers, usually hospitals. As a result, AMN’s core employees have enjoyed wage gains well ahead of those in the general economy in recent years and the company’s gross margins have expanded every year since 2008.

Solid conclusions

In addition to having businesses that sound decidedly low-tech and even unexciting, both LCI and ACM share other characteristics, such as solid balance sheets and high conversion of earnings into cashflow. Those things matter in any environment, but in one where interest rates might rise further our preference is for higher-quality business models that are sustainable even in the case of a policy mishap.

Recently, we have observed markets quickly and somewhat indiscriminately adjusting stock prices, presuming higher earnings as a result of the Tax Cut and Jobs Act. Now there is a more thoughtful reassessment of the real winners and losers of the evolving environment. We view small-cap companies as somewhat undervalued relative to the longer-term premium to large-caps which they deserve. We also recognise the need to be selective about which smaller companies to own. After all, the impacts of inflation, tight input markets and increased competition from companies “reinvesting their tax windfall into price competition” differ across companies. As a result, we look for a smaller and carefully selected group of companies that share strong financial characteristics and the ability to deal with the changes in an economy that has already been expanding for nearly nine years.