It’s only logical to expect that stocks of small companies would do better than those of large ones at times when the dollar is strong and rising, as it is now. After all, those small-caps generally rely less on international operations, and therefore have less exposure to currency effects that could reduce the dollar value of foreign sales and erode earnings growth.
Look, for example, at the numbers and forecasts that Microsoft and Procter & Gamble offered today in announcing their results for the final three months of 2014.
Microsoft Chief Financial Officer Amy Hood said that sales in China and Japan were weaker than expected, and that currency effects from a stronger dollar had hurt the company’s commercial licensing revenue more than anticipated. In addition, she warned that foreign exchange (FX) rates would eat into revenue growth by about 4 percentage points in the current quarter.
“Our guidance is based on our current view of FX rates,” Hood told analysts on the company’s earnings conference call. “Should the U.S. dollar strengthen beyond those assumptions, as it did this quarter, we would see additional negative impact to revenue, earnings, our balance sheet and our contracted but not billed balance.”
A year into CEO Satya Nadella’s tenure, Microsoft still faces a host of business challenges that, especially over the long run, will be much more significant and fundamental than the strength of the dollar. But the currency effects make it that much more challenging to please Wall Street. “Where there are execution issues, we will address them; and where there are macro-economic challenges, we will weather them,” Nadella promised. Investors, though, weren’t swayed, sending Microsoft’s shares 10 percent lower in early trading, quickly wiping out nearly $40 billion in market value.
Procter & Gamble CEO A.G. Lafley also pointed to currency effects in explaining why second-quarter earnings plunged 31 percent. “The October - December 2014 quarter was a challenging one with unprecedented currency devaluations," Lafley said in a statement. "Virtually every currency in the world devalued versus the U.S. dollar, with the Russian Ruble leading the way. “ Lafley said that foreign exchange would cut fiscal 2015 sales by 5 percent and reduce profits by 12 percent, or an after-tax minimum of $1.4 billion.
Other large-cap companies like Johnson & Johnson and Pfizer have also cited currency effects as affecting their earnings.
Apple, by contrast, showed that currency effects don’t have to ruin global earnings power. The iPhone maker on Tuesday reported the best quarter in its history, with $18 billion in profit on sales of $74.6 billion. Apple said international sales accounted for a whopping 65 percent of that revenue, including $17.2 billion from Europe and $16.1 billion from China, Hong Kong and Taiwan (up an astounding 70 percent year over year). As Ben Thompson points out in a post at Stratechery, currency effects crushed Apple's revenue to the tune of 5 percent, or $3.73 billion — more than the $2.83 billion Google made in profit last quarter. Apple's record-breaking quarter would have been billions better if not for the strength of the dollar.
Still, Apple and the iPhone 6 clearly have a somewhat unique ability to withstand the foreign currency flu. With other large companies already feeling the effects of a stronger dollar, perhaps it’s time to tilt your portfolio toward small caps?
History suggests otherwise, as Sam Stovall, chief investment strategist at S&P Capital IQ, wrote in a research note Monday. Since 1985, outside of bear markets, large caps have fared better than small-caps whenever the value of the U.S. dollar index was at 95 and rising. That index is now at 94.03.
And since January 1995, six of the 10 sectors in the S&P 500 have done better than their small-cap equivalents when the dollar was rising. (Consumer Staples, Health Care, Materials and Utilities were the exceptions.) So large caps aren’t doomed to lag smaller stocks. So far this earnings season, more than 77 percent of the S&P 500 companies reporting earnings have topped analysts' estimates, according to Bloomberg.
"I think the past couple of days have shown us that U.S. companies are not immune to global weakness, but those companies that are well managed and have the right products/services can stay afloat," corporate earnings analyst Christine Short of Estimize wrote Wednesday. "The S&P 500 is made up of large multinational companies that garner close to 40 percent of their sales from outside the U.S., so they really rely on global strength to succeed. This is not 2008 - 2009 when Europe was in recession, but China was putting up double-digit GDP and was able to offset weakness in Europe. With China moderating, U.S. companies can no longer count on strength there, and will have to find other ways to hedge."
Foreign investors seeking profitable places to park their money may help large U.S. stocks weather the global slowdown, Stovall suggested. “Yes, small-cap stocks have less foreign exposure, so their earnings will not be whittled down during the translation process. Yet many companies hedge their foreign currency exposure, so this becomes less of an issue,” he wrote. "More important, in my view, is that international investors are looking to the U.S. and pushing up the value of the dollar."
Stovall noted that estimates for U.S. GDP are rising, while those for many other economies are being cut. And U.S. companies overall are still expected to see earnings grow in 2015, while growth may be harder to come by for foreign businesses. That should lead to more international money flowing into U.S. stocks, Stovall posited, and foreign investors are more likely to put their money in larger and better-known companies.
“Therefore history says, and we agree, that the S&P 500 and a majority of its sectors will represent a better investment opportunity in the months ahead than their smaller-cap alternatives,” he concluded.
This article was updated at 12:25 p.m. on Wednesday, Jan. 28.
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