Analysis - With small caps, best to be choosy after U.S. tax overhaul

By Chuck Mikolajczak

NEW YORK (Reuters) - Investors have seen small-cap stocks as having the most to gain from a tax code overhaul ever since the 2016 U.S. election, but with a bill on the brink of Congress approval, analysts warned not all small names will benefit equally.

The Russell 2000 index has had its fortunes rise and fall based on the perceived chances of the tax plan's success. It surged nearly 14 percent in the seven weeks after the November 2016 election of U.S. President Donald Trump, who made a tax code rewrite central to his campaign.

Small caps in general are relatively sensitive to proposed tax cuts because more of their revenue is derived domestically compared to larger names with a greater global footprint.

"Small caps underperformed for most of the year and are best able to receive the boost from a tax cut," said Alicia Levine, Director Of Portfolio Strategy at BNY Mellon Investment Management in New York.

Despite the post-election bump, small caps have trailed bigger companies in 2017, having felt more pain whenever the tax plan appeared on the brink of failure.

The Russell 2000 tested a technical support level at its 50-day moving average on Dec. 14, when the sweeping bill seemed to hit obstacles as more Republican U.S. senators appeared to waver.

The index is up 13.6 percent on the year versus a nearly 20 percent climb in the S&P 500 and a more than 25 percent jump in the Dow Jones Industrial Average.

But as the small-cap index surged nearly 3 percent in the two session leading into the vote on Tuesday, some market participants cautioned a tax cut will not be a security blanket for all smaller names.

Some have yet to produce earnings, while some may be vulnerable to rising interest rates after taking on debt in the low rate environment following the 2007-2009 financial crisis.

"There's a misperception that broad based they'll do well," said Dan Hughes, vice president and client portfolio manager at Vaughan Nelson Investment Management in Houston, Texas.

One concern for small caps is valuation, with the forward price-to-earnings ratio of the Russell 2000 at 26.1, according to Thomson Reuters Datastream, well above the 21.5 median and 21.4 mean. That number rises significantly when companies that do not generate earnings are included.

"It's weird to say this - but earnings matter again," said Francis Gannon, chief investment officer at Royce Funds in New York.

"At a moment in time when people are looking at the index and thinking the index should benefit, the index is getting increasingly risky."

Gannon recommended economically sensitive and cyclical names that have fundamentals, are not heavily leveraged and are poised to benefit from expansion both globally and domestically. He flagged industrial and materials businesses, including steel and chemical companies.

(Additional reporting by Sinead Carew and Jennifer Ablan; Editing by Meredith Mazzilli)