April 22, 2015 / 5:19 AM / 5 years ago

As strong dollar weighs, not all small U.S. stocks are beautiful

NEW YORK (Reuters) - As the dollar’s rally gained pace since the start of the year, shares of small companies followed, bid up by investors betting that such firms will be largely spared currency headwinds faced by big multinationals.

One hundred dollar notes are seen in this photo illustration at a bank in Seoul January 9, 2013. REUTERS/Lee Jae-Won

Now, however, after investors have flung billions of dollars into small stocks and small stock mutual funds over the past several months, the “small is beautiful” strategy’s shortcomings are becoming apparent.

First, the rally made many of the members of the small cap Russell 2000 index expensive. Secondly, not all small firms offer the high degree of immunity from the strong dollar’s negative effect on U.S. exporters that investors expect.

“It’s very simple to say small cap is domestically focused, they are going to hold up better than large cap because of the currency,” says Bank of America Merrill Lynch small-cap strategist Steven DeSanctis. “That is not always the case.”

Some small firms generate as much of their sales overseas as their bigger rivals and might be even more exposed than large corporations that have hedging programs and operations spread across multiple markets to cushion the impact.

Other act as suppliers to big players that suffer from the dollar rally or compete against imports that have become cheaper.

Some may simply face other headwinds such as energy companies hurt by the slide in crude prices.

In fact, during the previous spell of dollar strength from 1995 to 2002 small stocks underperformed large caps by 4.8 percent as investors, rattled by the Asian currency crisis, chose more liquid and less volatile assets, according to an analysis by DeSanctis.

If the Federal Reserve sparks another flight to safety with an interest rate hike, small stocks could again suffer, especially given their already high valuations, DeSanctis said.

Russell 2000 stocks now trade at 24.4 times earnings compared with 17.1 for the large cap S&P 500 .SPX, according to Thomson Reuters data.

LOSERS AMONG WINNERS

So far in 2015, the dollar has risen 8.3 percent and the Russell 2000 - made up of companies with less than $4 billion in market capitalization - has rallied 5 percent, more than double the 1.8 percent increase in the S&P 500.

In March, retail investors put $1.7 billion into small cap mutual funds and exchange traded funds, while they pulled $11.9 billion out of large cap funds, according to Thomson Reuters data.

But those who invested in small cap energy sector .SPSMCE, for example, are looking at a loss of more than 44 percent since the start of July, when crude prices began heading lower, the dollar’s strength playing a part in the slide.

Examples of companies that rely on overseas markets also underscore the need for caution.

Helicopter manufacturer Erickson Inc EAC.O, which generated more than 60 percent of its 2014 revenue outside of North America and depends on the oil industry for a big chunk of its business, has seen its shares tumble 45 percent so far this year.

Weight Watchers WTW.N, which derives over 40 percent of its business from overseas, has said it expects the strong dollar to shave roughly 15 cents a share off of its projected annual 2015 earnings of 40-70 cents a share. Its share price is down nearly 70 percent for 2015 and the company has acknowledged the growing challenge from mobile calorie counting applications.

Yet other more domestically-focused weight management peers have fared better. Nutrisystem Inc NTRI.O shares have held steady over the same period while Medifast Inc (MED.N) has slipped 7.8 percent.

A spokeswoman for Weight Watchers declined to comment for the story and representatives for Erickson were unavailable to comment.

To be sure, several small companies are insulated from the dollar effect and doing fine.

For example, Drew Industries DW.N, a maker of components for recreational vehicles and manufactured homes, reported an almost 29 percent year-on-year rise in fourth quarter sales. Its shares are up more than 20 percent since the start of the year yet its forward price-earnings ratio of 18.3 is still well below that for the whole small-cap index.

“We are trying to focus on companies that are much more domestic oriented,” says Michael Corbett, chief investment officer at Perritt Capital Management in Chicago. Among his picks are several financial services companies, such as Hennessy Advisors (HNNA.O), Silvercrest Asset Management (SAMG.O) and Liberty Tax TAX.O.

But even those who cherry-pick such companies have to be aware that they are arriving late to the party.

For example, Texas Roadhouse (TXRH.O) is a U.S.-focused restaurant chain, but its forward price-to-earnings ratio is near its eight-year peak just below 25.

“I wouldn’t say that it shouldn’t (go higher) or can’t,” says Edward Hemmelgarn, chief investment officer of Shaker Investments in Cleveland, Ohio.

“But the price has moved up faster than the earnings have.”

Reporting by Chuck Mikolajczak; Editing by Linda Stern and Tomasz Janowski

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