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Time to shine for US small-caps?

US smaller companies could be a good way to diversify S&P 500 exposure if you can tolerate volatility
Time to shine for US small-caps?
  • US small-caps look cheap relative to the S&P 500 index and may offer some diversification
  • Funds focused on this area have delivered strong returns
  • But they can be very volatile

For all the talk of market rotations, 2021 has ended with a set of questions already painfully familiar to investors. Is the S&P 500 index now overvalued after a strong year and can it continue its stellar gains? This index again outpaced other major regional markets in 2021, but these gains are accompanied by fresh concerns that such returns have been driven by a handful of large tech stocks. From monetary tightening to any new Covid-19 developments, other events could put the world’s leading market off course in 2022.

So investors are yet again considering potential diversifiers to S&P 500 exposure. Different equity regions and asset classes can provide part of the answer. But there may be a way to do this while remaining invested in the US market. The Financial Times recently reported that the S&P 600, an index tracking the small-cap segment of the US market, was trading on a much lower forward price/earnings ratio than the S&P 500, putting smaller companies at a “historic discount” to bigger stocks. That reflects a gap in the performance of the two: the S&P 500 generated a sterling total return more than double that of the Russell 2000 between 1 January and 20 December 2021.

 

 

Many specialists remain cautiously optimistic on the US market as a whole. Writing in late December, Franziska Palmas of Capital Economics noted: “We still think the most likely outcome is that the Omicron wave will be brought under control, and that the economic recovery in the US and elsewhere will continue. We also don’t think that US equities are in the late stages of a bubble that is bound to burst.”

However, Palmas does expect gains in the S&P 500 to be more modest than before as the good news appears to be priced in, and because of the prospect of real yields rising as the US central bank, the Federal Reserve, tightens monetary policy and the general “elevated level” of valuations.

In this context, small-caps provide a way to focus on the strength of the US economy without such substantial concerns about valuation risk. But as the chart shows this can be a trade with big ups and downs: the Russell 2000 was extremely volatile in the last quarter of 2021 amid Covid-related wobbles in investor sentiment. So selectivity and cautious position sizing can be helpful when allocating to this area.

 

Funds for small-caps

US smaller companies-cap funds are surprisingly numerous and a handful of these have navigated the past two years especially well. These include Legg Mason Royce US Small Cap Opportunity (IE00B23Z8V29), which has managed to outpace the S&P 500 in both 2020 and 2021. The fund’s managers take a contrarian, value-minded approach, and its portfolio is split into several value investment themes including turnaround stories and “undervalued growth”.

The fund's managers are happy to pick through the rubble for potential bargains: the fund's November commentary noted that while US equities struggled during the month on the back of fresh Covid-19 concerns, this allowed for opportunistic stockpicking.

“Consumer retail is an example where many companies have everything investors want to hate in stocks right now: the resurgence of Covid, supply chain issues – where shortages are creating margin pressures – and higher energy prices, all of which are hurting some demand for retail while also leading the managers to add selectively to this area,” they explained.

The fund's managers have also been buying into share price weakness in the aerospace and defence sector.

This value approach, in theory, leaves the fund even more vulnerable to a snapback if markets struggle, but its managers remain cognisant of some of the big risks currently worrying investors. Their November commentary notes, for example, that they “continue to adjust position sizes based on their view of a company’s ability to deal with increasing pricing and pass-through costs”. They generally expect that business-to-business companies will fare better than consumer-facing businesses in this regard.

Like some other small-cap portfolios, this fund offsets risk via heavy diversification across different holdings – as we explained earlier this year in 'The smaller companies funds taking the biggest bets' (IC, 27 August 2021). Legg Mason Royce US Small Cap Opportunity had no fewer than 252 holdings at the end of November, with its 10 biggest positions making up just 7.1 per cent of its assets. The fund's biggest sector exposure was industrials.

Although its performance has been more in line with the Russell 2000 than the S&P 500 this year, Artemis US Smaller Companies (GB00BMMV5766) is fairly steady and has a good longer-term track record. It is more concentrated than some smaller companies funds as it typically has between 50 and 70 holdings, but a significant level of research goes into its investments. Rather than taking a purely bottom-up stockpicking approach – selecting companies on the basis of their individual merits – Artemis US Smaller Companies' manager Cormac Weldon conducts in-depth analysis of economic trends before deciding where to seek investments. Substantial analysis also goes into the assessment of potential holdings. The fund’s biggest positions at the end of November were Saia (US:SAIA), a shipping and logistics firm, and LPL Financial (US:LPLA), a broker-dealer that provides technology and services for financial advisers. Artemis US Smaller Companies has a relatively balanced approach when it comes to different investment styles.

 

In for the ride

Smaller companies' volatility is reflected in the performance of some funds such as JPM US Small Cap Growth (GB00B8H99P30). Its managers use a bottom-up process to find companies “with strong fundamentals that have the ability to deliver higher earnings growth than market expectations”. Its five-year returns are ahead of the other funds in its sector but it has had quite a mixed pandemic. The fund delivered an enormous 50.5 per cent total return in 2020 but was down by around 7.5 per cent between 1 January and 20 December 2021. Some of its woes might be explained by a recent chunky weighting to healthcare, a sector that has struggled this year. The Russell 2000 Health Care Industry index was down by nearly 16 per cent in sterling total return terms over the same period.

If US small-caps look cheap on some metrics, investment trust fans may well struggle to find obvious bargains. Brown Advisory US Smaller Companies (BASC) traded at a discount of 7.6 per cent to net asset value (NAV) on 20 December, roughly in line with the average for the preceding 12 months. JPMorgan US Smaller Companies Investment Trust (JUSC) was trading at a 4 per cent premium, so far from cheap versus a 12-month average discount of 0.3 per cent.