Small caps tend to earn a majority of their revenues domestically. Still, that may not insulate the stocks from the brunt of tariffs, says Craig Kempler, Portfolio Manager at Perkins Investment Management. This article gives his view on what investors can do.

There is much debate on how tariffs affect small-cap companies. When the prospect of new or rising tariffs first arose, many investors took the view that US small-caps would be immune because of their domestic focus. We did not share this view then, and do not now.

Tariffs typically manifest themselves at the company level in two main ways. First, from a demand standpoint, an increase in tariffs generally leads to an increase in prices. When prices rise, demand falls and growth rates decelerate. Second, when companies are unable to pass on a full price increase, they have to absorb a portion of the tariff, reducing earnings power and profit margins.

While we believe the US can weather the trade storm better than most countries, an increase in tariffs across a range of goods globally would be negative for growth rates and equity valuations broadly. Tariffs may benefit the companies that the tax is intended to protect, but the number of firms negatively impacted usually far outweighs the number seeing any benefit.

The impact on small caps

When it comes to small caps we think the US companies most at risk, from a profit margin standpoint, are consumer discretionary, technology and certain industrial firms. In the case of consumer discretionary and technology, many parts of these sectors’ supply chains run through Asia and China. Higher tariffs on Chinese goods have the potential to decrease the profit margins of suppliers, as they may be unable to fully offset the tariff increase with price increases. For many industrial companies, in addition to supply chains that also run through Asia/China, they often have significant exposure to Mexico as well. As such, heavy machinery and automobile manufacturers, for example, could be faced with margin compression should global tariffs increase.

Other challenges exist. In consumer discretionary and technology, price multiples remain elevated, making it difficult to find higher-quality names trading at reasonable valuations. Many industrials are tied to the economic cycle and finding firms with secular growth drivers could be critical in a rising-tariff environment. Even US companies with mostly domestic revenues could carry some risk. UniFirst, a maker of workplace uniforms, is one example. The company earns nearly 100% of sales domestically, but manufactures a portion of its garments in Mexico.

Stay focused on valuation / balance sheets

Given these factors, in today’s environment, we believe it is especially important for investors to focus on company balance sheets and valuation. In addition, some sectors, such as consumer staples, may be more insulated from tariff wars, since demand for basics such as food and household products is likely to persist (the sector could also eventually benefit from an improved trade deal with China, should one be reached).

In the meantime, we fully expect to see continued market volatility driven by the potential risk of rising tariffs. Historically, periods of uncertainty have presented opportunities to invest in high-quality companies trading at attractive reward-to-risk ratios. We think investors should be ready to take advantage of these temporary dislocations, when and if they appear.