A Strong Dollar Does Not Mean Large Cap U.S. Multinationals Underperfom Small Cap Equities

The US Dollar has been on a strengthening trajectory since early 2011 and more so since mid year last year. This move in the Dollar has been a headwind for U.S. domiciled multinational companies earnings, with many firms citing this as a reason for earnings disappointment during this earnings reporting season.

From The Blog of HORAN Capital Advisors

One belief is investors can avoid this negative currency impact within their investment portfolio by focusing more on small company stocks since small caps are less exposed to this exchange rate risk. The thinking is small cap companies generate a larger percentage of their overall business from domestic sources versus the larger multinationals that generate a larger portion of their revenue from overseas. In fact this seems to be the case during the earlier phase of the Dollar's strengthening as the above chart shows small cap outperformance from 2010 through most of 2013. However, as the Dollar continues to strengthen, larger cap companies actually outperform small caps as occurred in the mid 1990s. This can be seen in the below chart that compares the relative return of large caps versus small caps (orange line) to the U.S. Dollar Index.

From The Blog of HORAN Capital Advisors

S&P Capital IQ provided additional analysis in a report released in late January titled, Don't Duck A Rising Buck. In the report S&P analyzed the performance of large cap stocks versus small cap stocks during bear markets and bull markets and compared the results to the trend of the U.S. Dollar. The report is a worthwhile read for investors. In short, the data suggests large cap companies actually outperform small cap companies in a rising Dollar environment when the overall equity market is in a bull market phase. This outperformance occurs when the Dollar Index rises above 95 (closed Friday just below 95.) The report contains a sector performance comparison as well.

From The Blog of HORAN Capital Advisors

Source: S&P Capital IQ

There are several reasons this outperformance by large caps may occur when the Dollar Index is above 95 and when the equity market is in a bull phase. Foreign investors likely see the U.S. economy growing at a faster pace than other economies, and this is the case today. With this thinking, foreign investors will allocate investment funds to U.S. equities. In doing so, they tend to focus on larger multinational firms that are more broadly know. Additionally, larger equities are more likely to be more liquid. This additional investment flow into the U.S. and the investment in Dollar denominated assets further pushes the U.S. Dollar Index higher. For non U.S. investors then, they receive an additional return benefit from a positive currency exchange when Dollar's are converted back into their home currency.

Just one comment on small caps. At HORAN, we have been out of small cap equities since late 2013. A reason we chose to eliminate the category from our client allocations was partially due to the valuation of small cap stocks broadly. In a Reuters report today, Valuations May Hurt Small Caps, Despite Job Growth, the article cites the apparent overvaluation of small cap stocks. Specifically, the article notes,

"The trailing price-to-earnings ratio of the index is at 22.7, which is 40 percent more than its long-term average of 16.2. Its price-to-sales ratio of 1.6 is nearly 67 percent higher than its long-term average."

In summary, even though small caps are less exposed to overseas business, there are several factors that indicate large cap U.S. equities outperform in spite of the currency headwind. Additionally, the valuation of small cap stocks are likely to be a headwind for the small cap equity asset class.