Small-Cap Stocks Could Get a Big, Beautiful Boost

Companies with smaller market capitalizations could see larger tax deductions should the One Big Beautiful Bill pass. (Kent Nishimura/Bloomberg)

Investors in stocks with smaller market capitalizations might love President Donald Trump’s “One Big Beautiful Bill,” which would allow companies larger tax deductions, boosting profits.

Before the fun part—the part when we show earnings can rise significantly and that the stocks could go up—we must explain the accounting.

The new proposed rule says companies’ interest expense creates a tax deduction for interest that’s up to 30%—not more—of earnings before interest, tax, depreciation, and amortization (Ebitda). The current rule says interest is tax deductible if it’s less than 30% of Ebit.

But companies would prefer to use the new rule in the “Big Beautiful Bill,” which uses Ebitda, a larger figure, so interest expense is a lower percentage of it than of Ebit. The result: More interest dollars would become tax-deductible.

This is particularly beneficial for the small-cap universe, as embodied by the Russell 2000, versus the large-cap S&P 500. Smaller companies generally have greater relative debt burdens than the larger ones, so there is a large portion of additional profit dollars the Russell 2000 can enjoy from tax deductions.

The factor freeing up more of that interest expense to become tax-deductible is that Russell 2000 companies generally have relatively large amounts of depreciation and amortization (the last two letters of Ebitda). That means their Ebitda is much larger than Ebit, providing a larger denominator and allowing more interest dollars to become tax deductible.

Here’s how the numbers break down.

Barclays U.S. equity strategists say aggregate earnings on the Russell 2000 will rise 12% from current analyst forecasts.

The analysis starts with the fact that total interest expense on the Russell 2000 represented just over half of the index’s Ebit in the last 12 months, versus roughly 10% for the S&P 500. Immediately, we know there are many interest dollars that can become tax deductible for small-caps.

Large amounts of those interest dollars would become eligible for tax deductibility. The Russell 2000’s 2024 Ebitda, excluding financials, was $196 billion, far larger than Ebit of $87 billion because depreciation and amortization expense was $109 billion.

That larger Ebitda figure is key: it means interest expense has recently been roughly a quarter of nonfinancial company Ebitda—under that 30% rule—enabling companies to enjoy the tax benefit. It’s way less than a quarter of total Ebitda inclusive of financial firms.

The best news of all is that analysts expect aggregate Ebitda for the Russell 2000 to grow this year. Sales are growing as continued economic growth and mild inflation allow for more goods sold and at higher prices. This should be enough to lift profit margins slightly, which is why FactSet data show analysts expect about 15% Ebitda growth this year. Forecasts don’t call for much change in interest expense, so the higher Ebitda creates a tax benefit.

Overall, the tax benefit for Russell 2000 companies would total tens of billions of dollars, creating a significant boost to earnings. The index’s aggregate earnings—or bottom-line net income—is currently expected at less than $200 billion.

So let’s assume Barclays’ estimate for a 12% earnings boost is about right. It’s a major boost, and would lift the index. Sure, the Russell 2000’s gain of just over 3% in the past five trading days could reflect some anticipation of higher earnings, as the budget bill moves through Congress.

But first of all, that’s not nearly as much as the potential earnings boost, and secondly, the bill hasn’t passed yet. As it moves closer to passing, if the probability rises that the tax rule remains as is, the index could continue to rise to reflect higher profits.

Even with the recent run-up, the Russell 2000 still isn’t very expensive, so any increase to expected earnings could easily boost the stocks. It trades at just over 23 times current expected earnings for the coming 12 months, only about 6% above the S&P 500’s just over 22 times, a slim premium. Over the past decade, the Russell 2000 has averaged a premium of more than 30% to the S&P 500, according to our calculations of FactSet data. That’s why this bill’s profit implications could soon catalyze stock gains for small-caps.

In the near term, “Some rotation into small size…should be expected,” writes 22V Research’s Dennis DeBusschere.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com