US funds: small is beautiful

By Leonora Walters, 11 November 2010

Everything in the US is on a giant scale. Towering skyscrapers, six-lane freeways, huge cars and belt-busting restaurant portions are all a feature of life across the pond. But when it comes to stock market performance, big certainly isn't better. While the S&P500 has returned virtually nothing over the past decade, US small-caps have delivered 60 per cent returns.

This has been reflected in the performance of US small-caps funds: over five years, North American Smaller Companies is the twelfth best performing Investment Management Association (IMA) fund sector, out of 31 sectors. North America (large-cap focused funds) are at 26. Over one year meanwhile, North American Smaller is the second best performing fund sector, while North American large-cap focused funds roll in at number 10.

And advisers are adamant that, for all the attractions of emerging markets, investors should still have some sort of allocation to the US. "The old argument remains...although power is shifting, the US is still a considerable market so you need some exposure," says Justine Fearns, research manager at independent financial advisers AWD Chase de Vere. "This is still the largest economy."

Your level of exposure depends upon your risk profile, she adds, though 15 per cent is about right for a balanced risk investor.

US fund managers also say that despite the uncertain economic outlook, high unemployment persisting and a struggling housing market, the economic picture is beginning to improve. Personal savings rates have moved up from close to zero to around six per cent, while the housing market is now at, or near, the bottom.

Andrew Holliman, US fund manager at Threadneedle Investments, adds that in any case, you invest in the stock market, not the economy: "We are more bullish on the prospects for investing in the US than the prospects for headline GDP growth," he says. "There are numerous drivers which should result in US earnings, cash flow and dividend per share growth being higher than nominal GDP growth.

Foremost among these is cash flow. "This should be a particularly important driver – US corporate balance sheets are in very fine shape and free cash flow generation by US companies is moving off the historic charts."

This year, North American companies generally have beaten earnings expectations and while the US does not have the growth prospects of emerging markets, it can still achieve superior investment performance over the long term, argues Robert Siddles, manager of F&C US Smaller Companies investment trust.

Drilling down

There are good opportunities to exploit these investment opportunities among smaller companies, argue managers focused on this area. Small-caps tend to out perform large-caps over the longer-term, a trend which in part reflects their higher growth potential, though it means you need to have a long-term time horizon to invest in them. "Small-caps offer more exposure to the US economy and the entrepreneurial opportunities," says Marc Shaw, portfolio manager on the JPMorgan US Smaller Companies investment trust.

Mr Siddles also argues that smaller companies have proved to be a good hedge against inflation in past periods such as the 1940s and 1970s, which could pick up after the US central bank announced a $600bn second round of quantitative easing.

He highlights the large number of stocks available at this end of the market – there are more than 3000 companies valued between $100m and $5bn – with many attractive niche opportunities. Smaller-caps are less researched than large-caps, giving managers the chance to find well priced opportunities.

Valuations

What about valuations? "In the Russell 2000 index you should be able to find 80 to 100 good stocks at reasonable valuations, although not as good as in 2009," says Mr Shaw. He and others note that US small-caps have enjoyed a strong re-rating over the past year.

For this reason, some argue against exposure to US small-caps. "Large-caps will be better over the next five years," says Mick Gilligan, head of research at stock brokers Killik & Co. "Valuations of small-caps have experienced a significant re-rating over the last five years so that they are at a significant premium to large-caps, which on balance are more resilient businesses."

Jim Cullen, portfolio manager at Cullen Capital Management, argues that the US is entering a post recessionary boom for dividend paying stocks – and these are typically found among larger rather than smaller companies.

However, Mr Siddles contends that valuations are still historically low, and that you would have to go back more than 25 years (stripping out the financial crisis) to find similar levels. "Current valuations are at levels usually only seen in a crisis, which is not where we think US small-caps are at present," he says.

Added to that is the higher risk profile of smaller shares; just like their UK cousins, they are likely to have erratic liquidity and wider bid-offer spreads.

Another consideration for UK based investors is the strength of sterling against the US dollar. "If sterling rises against the dollar, positive returns on the other side of the pond can be turned into negative or at least reduced returns," says Ms Fearns "It is not a reason not to invest or not, but should be taken into consideration."

The latest $600bn round of US quantitative easing could also lead to a weaker currency, leading advisers such as Adrian Lowcock, senior investment adviser at Bestinvest, to suggest investors stick to regions of economic growth such as Asia. One way of getting exposure to these is to buy larger-cap US shares with international revenues.

Since both small and large-caps have positive and negative attributes, Ms Fearns advocates a blend between the two. "It is foolhardy to expect mega returns from small-caps in the next few years but over the much longer-term they should produce strong returns," she says. "A blend between the two helps provide an additional element of diversification and hopefully aids in trying to beat a market. An all-cap fund has this potential."

Individual fund choices

Ms Fearns recommends Neptune US Opportunities which she says has a flexible approach, as well as the Threadneedle American and American Select Funds. She also likes the Schroder US Mid-Cap fund, which can also hold smaller companies.

There are only seven North American small-cap funds to choose from, among which one of the stronger performers is Threadneedle American Smaller Companies Fund. There are further open-ended options offshore.

Passive funds which cover small-caps include db x-trackers Russell 2000 ETF and ETFX Russell 2000 US Small Cap Fund, both of which have lower total expense ratios than actively manged funds. However Ms Fearns argues: "At the moment active is probably better as it is a stock pickers' market. And when investing in small-caps you should always have an active fund because you don't want bad investments in this area as the risk here goes up substantially. This area is also less researched so a good manager can add value."

Four investment trusts focus on North American Smaller Companies, and over longer periods the best performer is F&C US Smaller Companies.

North American smaller company funds

Source: Morningstar as at 5 November 2010. All figures are for total returns.

North American smaller company investment trusts

Source: Morningstar as at 5 November 2010. Figures are for total NAV returns.

Profiles of key US funds:

visible-status-Public story-url-BigTheme_USsmaller_12.11.10.xml