With the US election having just taken place, it’s no surprise the investment world is focused on the largest global stockmarket as we head towards the year end.
Buoyed by the performance of technology stocks, investors in US large caps have enjoyed very healthy returns in recent years, but such has been the extent of this performance that many now believe the sector to be overvalued.
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Step forward US small caps. According to FE fundinfo, over the year to 24 October, the Russell 2000 is up 8.5% versus a 19.8% return from the S&P 500. However, unlike the S&P, not only do US small caps arguably offer better value, they also come with less concentration risk, argue proponents of the sector.
This month, Neil Birrell, Premier Miton chief investment officer, and Olivia Micklem, co-manager of Artemis US Smaller Companies, delve deeper into the asset class.
Neil Birrell, lead manager, Premier Miton Diversified fund range
Multi-asset investors must constantly scrutinise global markets to evaluate the relative risk and return profiles of asset classes, looking for growth and income return as well as portfolio diversifiers. For the Premier Miton Diversified fund range we look both at asset classes as a whole and, crucially, which sub-sectors of the asset class are favourable. Within equities, we believe US smaller companies offer compelling opportunities for long-term investors.
So why hold US smaller companies in a multi-asset portfolio at all? The bottom line is they offer strong potential for capital growth.
Smaller companies in any market typically have better long-term growth potential than their larger peers as dial-shifting growth is easier to achieve if you are starting from a smaller base. They are also often more innovative and nimble, which can help fuel growth.
What makes US small caps so compelling versus smaller companies in other markets is the remarkable US economy. The US is by far the largest economy among its developed market peers, and rather than Europe and Japan whittling away its lead, the US’s relative position has strengthened since the financial crisis. It has vast and highly liquid capital markets, an internal market of over 330 million people, many of the world’s best universities, and its soft power and entrepreneurial culture is a magnet for global talent.
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Yet these fundamentals have largely been in place for years, so why is now is a good time to consider US smaller companies? Two factors stand out.
One is the US’s medium to long-term growth prospects versus other economies. Having done well in recent years, the country’s strong position in key transformative technologies, abundant natural resources and energy, and strong demographics relative to most peers point to continuing US prosperity. This is not to downplay the opportunities in other economies, but the US has superior prospects to many of its developed competitors.
The other key reason for considering US small caps now is the valuation gap between them and US larger companies. Since the financial crisis, large-cap US companies have outperformed their smaller peers meaning that on some key valuation metrics they are undervalued. Given that small caps have historically outperformed large caps for extended periods, now looks an opportune moment to enter the asset class.
In the Premier Miton Diversified growth funds we hold several US small caps. As mentioned, we focus on holding good companies in our equity portfolios, rather than blanket allocations to whole asset classes. Even in an asset class that is anticipated to perform well, there will be strong performers alongside duds, and we try to find the former while aiming for the right asset allocation decisions.
Installed Building Products, Service Corp International and Graphic Packaging are all US smaller companies we hold in our global equities portfolio. These companies operate in diverse industries, including building insulation, packaging and death care, and showcase the breadth of quality investment opportunities available.
While positive about US smaller companies we remain aware of their inherent risks. Small caps typically have fewer resources to fall back on in tough times and can have less robust governance and disclosure controls than larger peers. While not particular to US small caps, we are cognisant of the political background and the large Federal deficit as possible headwinds.
Through portfolio diversification we aim to manage these risks, while still capturing the long-term growth potential of quality companies in the asset class.
Olivia Micklem, co-manager, Artemis US Smaller Companies
Our hunting ground for US small caps is the Russell 2000. But to UK investors’ eyes, the companies in this index look far from small. The average market capitalisation is $3.5bn (£2.7bn) and the largest stock in the index has a market cap of $15.4bn. These companies are active in and a product of the most developed venture capital market in the world, which drives innovation and growth, and makes for a highly dynamic environment.
One of the key characteristics of smaller companies is their domestic focus. Unlike the S&P 500, which is dominated by global companies with international revenues, the Russell 2000 derives almost 80% of its revenues from the home market.
As a result, as well as accessing the growth of the world’s largest economy, we see investing in US smaller companies as a way of more directly capturing the intricacies of the US economy. Given the size and diversity of the US market – essentially 50 economies in one – it is inevitable that some states will be performing better than others at any one time. The breadth of the smaller companies market means we can target specific themes by buying companies focused on a particular industry, service or geographic area.
One of the themes we have invested in over recent years is ‘post-Covid recovery’. The distortions in supply and demand produced by the pandemic are still being played out across different industries. In many cases there has been a dynamic of rapid inventory growth leading to oversupply, followed by destocking and depressed pricing.
Elevated demand for consumer electronics and internet infrastructure during the pandemic created a corresponding boom in demand for hard disk drives and NAND flash storage. Once the pandemic ended, demand growth slowed, inventory ballooned and prices fell. The industry responded by cutting capacity. Demand started to return and prices stabilised. We got exposure here by buying one of the leaders in hard disk drives and NAND flash storage.
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This also forms part of another of our themes: the build-out of data centres. Substantial investment in AI and cloud computing has fuelled significant investment in data centres, which require a number of components that are highly complex and require specialist labour to build and service. We are exposed on the hardware side, the labour side, as well as the power side through holdings in independent power producers.
More broadly, infrastructure investment across both public and private sectors is huge. The state of roads, bridges and water infrastructure in the US is poor after years of underinvestment. To capture this tailwind, we have exposure to a number of businesses that will provide the means to replace and repair areas that have been highlighted as key areas of focus.
Outside of holdings exposed to macro tailwinds, a large proportion of the fund is exposure to idiosyncratic stories where the company fundamentals are the sole drivers of our conviction. This covers a broad range of holdings across clothing, cosmetics, life sciences, technology and financials, to name a few.
We remain confident in the long-term opportunity within US smaller companies, in part due to the unique features they offer investors, but also due to the fact that profitable smaller companies are trading at near historical lows versus large caps. We believe this is a good entry point.
This article was written for our sister title Portfolio Adviser’s November magazine
