JPMorgan US Smallers focused on long-term gains

“It’s about finding companies with higher earnings growth and potential returns,” he explains. “And the average small-cap has five or six analysts versus double that for large-caps, and many of the names we own are covered by fewer than three analysts. This gives us the ability to have an edge, and find opportunities that are misunderstood. We welcome any pullback in small-caps as it allows us to buy our favourite companies at a cheaper price, while still confident that we can make strong returns over the next decade.”

Despite recent underperformance versus large-caps, JPMorgan US Smaller Companies Investment Trust has a very good record of beating its benchmark, the Russell 2000 index. This year it has been helped by holdings in the consumer discretionary, financial services and producer durables sectors.

“An overweight position in Pool Corporation (US:POOL), a wholesale distributor of pool equipment and supplies, was among our top contributors,” says Mr San Jose. “It reported better-than-expected earnings during the year, but a key driver of its outperformance was general investor preference for companies with defensive business models amid macro and trade-related uncertainty. Although we trimmed our position [in Pool] on strength it remains a core holding. We appreciate the visibility in the business from a recurring revenue stream and remain confident in its management’s strategy and business fundamentals.”

Mr San Jose and his colleagues do not pick companies according to which sector they are in but rather on the basis of their individual investment merits. “Our sector weights are a by-product of our bottom-up investment analysis and disciplined approach to portfolio construction,” he explains. “We adhere to a consistent investment process, which focuses on identifying companies that have a sustainable competitive advantage and durable business model, and are overseen by a competent management team with a track record of success.”

So, for example, the trust had over 17 per cent of its assets in consumer companies at the end of September – despite concerns among some analysts that the US/China trade dispute could make goods more expensive and reduce US consumer spending.

This year it has been helped by holdings in the consumer discretionary, financial services and producer durable sectors

"In the consumer space, we continue to find many ideas which meet our investment criteria so retain a sizeable overweighting in this sector relative to the benchmark," says Mr San Jose. "We tend to be more biased to leisure rather than retail [via holdings including] Pool; Brunswick (US:BC), which makes marine engines, accessories and leisure boats; and Malibu Boats (US:MBUU). [However] pressures on corporate profits as well as tariff concerns have been weighing on business investment and small-caps are not immune from this. We feel that 2020 earnings expectations for both large- and small-caps seem a little too high right now and expect them to come down. It’s too early to tell [by how much] – particularly when you try to factor in the potential impact from tariffs. So we also have to pay attention to the macro. But right now consumers, who are the driving force behind US gross domestic product (GDP), seem happy and healthy.”

Mr San Jose and his team also aim to buy companies they consider to be trading at a discount to intrinsic value while avoiding ones that are cheap for a reason.

“In addition to valuation, we focus on the quality of the business and management team,” he explains. “Our fundamental analysis focuses on the quantitative business/product and management factors as well as the qualitative financial factors. There are always business sectors and companies that are out of favour, and our research involves separating those with strong long-term prospects from those that exhibit deteriorating business fundamentals or experience deep cyclicality. This is a critical component of our investment process and helps us to avoid value traps.”

There have been times when this approach has not worked. “We will never get everything right,” says Mr San Jose. “But we just need to be more right than wrong. And we give our investments time to work through any issues so don’t expect them to [do well] from the first day [that we invest in them]. For example, we bought Evoqua Water Technologies (US:AQUA) in the fourth quarter of 2017 and exited in the fourth quarter of 2018 after the company reported two consecutive disappointing quarters in only its first year as a public company. Management blamed acquisition system integration issues, supply chain disruptions influenced by tariffs and an extended delay on a large aquatics project. The municipal business did not prove to be as stable as we thought in our initial thesis, nor did management seem to fully comprehend the steps necessary to improve organic growth and profitability.”

Despite saying that “valuation is always on our minds” Mr San Jose and his team do not describe themselves as value investors though admit a value bias.

“A disciplined approach to valuation can enhance long-term returns,” says Mr San Jose. “A characteristic of our valuation approach is the recognition of the fallibility of reliance on earnings per share (EPS) forecasts. We use quantitative and qualitative valuation techniques to identify the intrinsic value of each company, and capture all sources of value in relation to companies, sectors and markets. We analyse stocks on the basis of their long-term – three years or more – investment merits."

They look at quantitative data such as enterprise value, free cash flow yield and private market value. And their qualitative analysis includes looking at EPS predictability relative to expectations, their level of confidence in managements and competitive positions of companies, the predictability and durability of businesses relative to their valuations, the level of business risk in companies' end markets, and their own evaluation of any short-term changes.

So far this year they have added seven new holdings to the trust, including AssetMark Financial (US:AMK), which provides technology services to financial advisers.

“We were attracted to the company’s strong management team which has a track record of organic flow growth, margin improvement and value creation,” says Mr San Jose. “The company has strong recurring revenues – around 95 per cent of fees are asset-based – and the critical nature of its services, such as client reporting, account opening, billing and compliance, ensures high levels of retention. AssetMark's financial model is compelling – it has strong organic growth, low capital intensity and high earnings before interest, tax, depreciation and amortisation (Ebitda) margins supporting strong and consistent free cash flow generation. Also, the valuation is reasonable for this asset – especially given the financial sector’s maturity and broader concerns about credit risk and interest sensitivity at regional banks.”