On the heels of the greatest short squeeze in history, US Small Cap stocks have been the 'go-to' 'safe-haven' as President Trump wields his trade war at 'multi-nationals'. It's an easy narrative to believe in - small caps are more domestically-focused (lower international sales), so buy them instead of large caps as protection from the what's happening to the rest of the world.

And it's been working...

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But in the last few days, the straight line bid for small caps has faded a little... 

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And this is why.

As Barclays explains, simply looking at international sales is quite misleading.

What really matters for estimating the impact of tariffs are the actual imports and exports and margins. Figure 13 shows the import/export values for small caps and large caps, as well as the impact on EBITDA in an all-out trade war scenario (10%tariff on all imports by U.S., 10% retaliatory tariffs by trade partners on exports).

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Note that these numbers are across all trading partners and not just China. We switch to EBITDA rather than net income as in the previous section since a significant fraction of Russell 2000 companies already have negative earnings.

The row labeled Model A uses our original methodology and approximates the Exports/Sales ratio for each small cap stock with the NAICS industry Exports/Sales ratio. Although this assumption is reasonable for large caps, it likely to break down for small-cap stocks, due to small-cap companies being less likely to have foreign operations. Thus for small-caps, the Exports/Sales ratio is likely to be closer to International Sales/Sales ratio. Thus for calculating the impact of tariffs for small-cap stocks we need to repeat the calculation we did for the China qualitative tariffs for large caps. The big difference is that for small caps this applies for all trade partners. We label this calculation as Model B in Figure 13.

We broadly see that the EBITDA impact on small caps is actually higher than large caps under Model A and becomes substantially worse under Model B. The worse impact under Model A is driven by three factors:

• While small caps have lower international sales as a % of total sales than large caps (20% vs 30%), their export/sales is only slightly lower (5.5% vs 6.6%).

• Small caps have significantly weaker EBITDA margins, resulting in a higher % of earnings loss for the same increase in costs relative to sales.

• While small caps have Export/Sales ratio relative to large caps, their Imports/Sales ratio is much higher. Thus the impact of import tariffs (imposed by the U.S. government) is likely to be much higher than large caps.

Finally, small caps would perform much worse under the Model B scenario(4.3%to 14.8% impact on EBITDA) since International Sales are much higher than the Exports estimated using the economy-wide export data. We emphasize that the actual impact is somewhere between Model A and Model B but from clearly based on our framework the impact on small caps is likely to be worse than large caps even though the former are more “domestic”.

Thus in summary, paradoxically despite their domestic nature, small caps are likely to be more severely impacted by a global trade war and we believe their risks are asymmetric to the downside.