JPMorgan US Smallers waiting for better valuations

The trust's manager, Don San Jose, says the trust's shares did very well till July last year so this is maybe a catch-up effect. Investors have also been taking profits in US smaller companies and turning to larger ones.

Many investors consider that US large caps are expensive, but while US smaller companies are also at elevated multiples Mr San Jose says that large-caps have run more over the last 18 months so the gap has closed. US smaller companies were on 21.2x forward earnings at the end of April in contrast to a historical range of 14x to 16x.

Reasons for the high valuations include mergers and acquisitions (M&A) by large and mid-cap companies making strategic purchases, and year to date three of the trust's holdings have been taken over, with two in the second half of 2014. "We have not seen activity like that since 2006/07," says Mr San Jose.

He doesn't want to see small companies making acquisitions at excessive valuations. Last year he sold property search website Zillow (Z:NSQ) because it bought competitor Trulia "at a price which did not make sense". "There is such a focus on growth some people don't do acquisitions as a strategic decision, and this is bad for value creation in the long-term," he says.

Other reasons for selling a company include a dramatic change in its strategy, and there are "always valuation discrepancies which offer the opportunity to trim."

The trust's investment team will also sell if the quality of the business or management is not as good as they thought, expectations for it are too high or the market over values it, or it can be replaced by a better idea.

They favour quality businesses with good managements, and are "very valuation disciplined", thinking not just about potential upside but also potential downside. When looking at valuation, the trust's investment team consider:

■ Price/earnings

■ Price/book value

■ Private market analysis

■ Free cash flow yield; and

■ Enterprise value analysis, for example considering transactions between companies similar to the ones they are looking at.

The trust's portfolio is on 17.9x forward earnings, and Mr San Jose says it tends to trade a bit under the market valuation. "It is harder to find companies at valuations below their intrinsic value at this point in the cycle, and our new idea generation has not kept up with previous years," he says. "No new names were added in the first quarter, and only two in the second quarter. This reflects valuations and the market, and because we stick to our knitting and look for compelling valuations. Normally we buy 12 to 15 new names a year."

He considers current valuations to be a key risk.

However, if there is a pull back in the second half of the year when he expects some volatility due to the possibility of interest rate rises, he might add new names. The trust's investment team favour companies with lower market risk that offer some protection in down markets, and tend not to invest in companies under $300m in size because it is hard for these to meet their quality standards.

In any case, they hold shares for long periods with around nine out of 10 held for 4.5 years or more, resulting in a low turnover of 20.9 per cent.

But overall Mr San Jose still thinks US smaller companies are worth investing in as they are a better way to get US exposure, with around 80 per cent of their revenues domestically generated. "They include innovative companies that serve market niches and can be a way to get in early on innovation," he says. "They are not necessarily affected by some of the themes that affect large-caps, and over the longer-term they have outperformed them."

Smaller companies are also less researched so offer more inefficiencies for investors to exploit.

Sector division

Mr San Jose and his team pick companies according to their individual merits rather than sector or macro-economic considerations, and the sector splits are result of this and their investment philosophy. "For example, we tend not to hold much in technology because the product cycles evolve quickly so it is hard for them to have a long-term competitive advantage," he explains. "We tend to shy away from volatile companies and sectors, and be in more mature smaller companies."

The trust is underweight health care relative to the Russell 2000 Index "because we avoid biotech, as in these companies you often get no cash flow, profits or sometimes even revenue," he adds.

The largest sector exposure is financials, nearly a quarter of assets at the end of April. While Mr San Jose likes the fact that sub sectors such as banks, financial data & systems companies, and real estate investment trusts (Reits) should benefit from a rising rate environment, the bank holdings are "because of the confidence we have in the individual ones we own."

Banks account for 10.8 per cent of assets and tend to be focused on business customers rather than consumers, and are based all over the United States. Most of these have an asset base below $10bn as this means they are subject to less regulatory scrutiny.

Holdings include Associated Banc-Corp (ASB:NYQ) and BankUnited (BKU:NYQ).

Consumer discretionary accounts for a fifth of assets - companies with a focus on return on capital, strong free cash flow and brand loyalty. "We look for companies with specific drivers such as new products, shareholder friendly policies like share buybacks and which are not entirely dependent on consumer improvement nationwide," he says.

Large ticket items such as cars, boats and home appliances have done well for a few years and holdings include Malibu Boats (MBUU:NMQ) and Patrick Industries (PATK:NSQ), which manufactures products for recreational vehicles and housing.

Source: Morningstar, *Winterflood, **JPMorgan.

Share price performance vs index

Source: Winterflood as at 8 June 2015

TOP 10 HOLDINGS as at 30 April 2015 (%)

Sector breakdown (%)