US-listed large-caps shone last year with shares in mega-caps, and the ‘Magnificent Seven’ in particular, surging higher. However, this outperformance only widened the valuation gap between US large and small-caps and left shares in the latter cohort languishing at the low end of historical valuations.

Over one and five years, the Russell 2000 index of US small-cap stocks is up 14.6% and 30.5% at the time of writing. That lags the performance of the S&P 500, which is up 26.2% over one year and 80% over five years. The tech-heavy Nasdaq index has chalked up gains of 33.2% and 104.6%.

While investor sentiment towards America’s market minnows remains weak, the asset class will enjoy its day in the sun once more since US small-caps offer investors the benefits of rapid growth beyond the Magnificent Seven, and US small-caps actually began to outshine their larger brethren towards the back end of 2023, suggesting conditions are ripe for a rebound.

As the late, great investment sage Jim Slater once said, ‘elephants don’t gallop’, meaning small companies have the capacity to grow much faster than big ones. Along with the capacity for superior growth, small-cap companies are also more likely to be taken over. Given it is the deepest and best-performing major stock market with the best governance, the US offers fertile ground for stock pickers seeking to diversify their US equity exposure by investing in a wider pool of smaller, but no less dynamic, companies.

WHY INVEST IN US SMALL-CAPS NOW?

Investors who limit themselves to the S&P 500 are letting a plethora of world-leading smaller US-listed firms slip through their fingers. As Kepler analyst Alan Ray pointed out in a recent note (27 March 2024) on JPMorgan US Smaller Companies (JUSC): ‘When a few stocks drive the performance of a whole stock market, it’s very easy to forget about important disciplines such as diversification and valuation, and JUSC offers both to investors looking for US equity exposure, with the additional potential kicker that smaller companies have historically performed extremely well at the tail-end of inflation and interest rate cycles.’

Despite the volatile geopolitical backdrop, prospects for the US economy upon which smaller companies have a greater dependence remain pretty favourable. Consumer spending is holding up well, supported by continuing jobs growth and rising wages, while falling inflation and interest rate cuts should provide a positive backdrop for US equities, and sentiment could shift away from the mega-caps and towards US small-caps given their sensitivity to the local economy and interest rates, their attractive valuations versus large-caps and the fact many investors have little exposure to the asset class.

The US small-cap market remains under-researched by Wall Street analysts, which means smaller fry are often seriously mispriced. Merger and acquisition activity in small-caps was dormant in 2023, but an awakening in the coming years would be positive for the funds which invest in this space.

As Chris Berrier, manager of Brown Advisory US Smaller Companies (BASC), said at the investment trust’s first-half results (12 February): ‘Although it may take some time to manifest itself, we believe in a future of sustained small-cap leadership. In our view, the market is simply too concentrated - the largest five names by market capitalisation are three times the total Russell 2000 Index - and the historical evidence too strong to ignore the category’s potential. Although we cannot say the area is a steal (i.e., cheap), we remain off the highs, relative valuation is compelling, and we believe the size segment should move as capital disperses from the Magnificent Seven.’

PROFESSIONALLY-MANAGED EXPOSURE

Specialist funds in this space include the Cormac Weldon-managed Artemis US Smaller Companies (BMMV576), which has generated a one-year total return of 32% and offers exposure to building materials supplier Builders FirstSource (BLDR:NYSE), trucking company Saia (SAIA:NASDAQ) and frozen French fries producer Lamb Weston (LW:NYSE) among others.

A stand-out five and 10-year performer is CT American Smaller Companies (B8358Z8), awarded a five-star rating by Morningstar, whose top holdings include American energy concern Avista (AVA:NYSE) and investment bank Moelis (MC:NYSE), while Jonathan Moyes, head of investment strategy at Wealth Club, highlights T. Rowe Price US Smaller Companies (BD446P5). This fund has returned more than 80% over five years and provides exposure to many small and mid-sized US firms that an S&P 500 index tracker would miss.

Investors aren’t exactly spoilt for choice when it comes to dedicated US small-cap investment trusts, with just two funds sitting in the Association of Investment Companies’ (AIC) North American Smaller Companies sector.

However, at roughly 40% of its geographical allocation, North America is the biggest regional exposure for the Global Smaller Companies Trust (GSCT). Managed by Peter Ewins and Nish Patel and trading on a double-digit discount to NAV, this AIC ‘Dividend Hero’ has raised the shareholder reward for the last 53 years.

Other options include Katie Potts-managed Herald (HRI), the TMT-focused vehicle with just under a third of its assets in North America, Baillie Gifford’s Edinburgh Worldwide (EWI) with over 70% of its portfolio invested in North America and Smithson (SSON), the quality global small and mid-cap trust with almost 45% of its assets in the USA at last count.

As the table shows, the superior 10-year share price total return performer among the two dedicated trusts is JPMorgan US Smaller Companies, up 157.2% versus a 110.1% gain for Brown Advisory US Smaller Companies, although the latter is ahead over one year.

Led by Don San Jose since 2008, the team at the former emphasises a hands-on approach to investing, preferring to ‘walk the floor’ of its investee companies to really get to know them, while the latter is managed by experienced US small-cap investor Berrier, who is ‘eagerly’ anticipating ‘a return to small-cap market leadership, from which BASC will be well-positioned to benefit in the long-term’ and believes now is the perfect time to invest in US small-caps.

Brown Advisory US Smaller Companies’ ‘3G’ approach - seeking businesses with durable Growth, sound Governance and scalable Go-to-market ability – helps to concentrate Berrier’s gaze on companies with an above-average potential to compound earnings and cash flows over a multi-year period. The trust’s largest holdings include Waste Connections (WCN:NYSE), a non-hazardous solid waste collection services play, as well as Midwest convenience stores operator Casey’s General Stores (CASY:NASDAQ) and social networking site Pinterest (PINS:NYSE).

TWO GREAT WAYS TO PLAY US SMALL-CAPS

VT De Lisle America Fund 

(B3QF3G6) 743.95p

Ongoing charge: 1.05%

Offering exposure to the US small-cap value style is VT De Lisle America (B3QF3G6), the five-star Morningstar-rated fund which aims to ‘look beyond Wall Street’ for missed or ignored opportunities rather than the big tech growth stocks which dominate many US funds. Manager Richard De Lisle invests in US small-cap value, the best long-term asset class in the world according to Nobel economics laureate Eugene Fama and his research partner Kenneth French, which makes VT De Lisle America’s portfolio of 179 stocks a good complement to existing US equity exposure. VT De Lisle America uses a top-down thematic investment process combined with forensic bottom-up analysis, searching for companies exhibiting high-quality metrics with attractive valuations. Top 10 positions include Cameco Corp (CCJ:NYSE), the world’s largest publicly-traded uranium company, American teddy bear, stuffed animal and character retailer Build-A-Bear Workshop (BBW:NYSE) and late 2022 spin-out MasterBrand (MBC:NYSE), formerly the kitchen-cabinet division of Fortune Brands (FBIN:NYSE). Another notable holding is Super Micro Computer (SMCI:NASDAQ), renowned for its energy-efficient servers, which recently left the Russell 2000 and entered the S&P 500. VT De Lisle America has generated annualised 10-year total returns of 14.3%, ahead of the 11.6% from Morningstar’s US Small-Cap Equity benchmark.

JPMorgan US Smaller Companies Investment Trust

(JUSC) 400p

Discount to NAV: 12%

Ongoing charge: 0.95%

A 12% NAV discount presents a compelling entry point into this quality growth-focused trust, which invests in US smaller companies with sustainable competitive advantages and competent management teams which the portfolio managers Don San Jose, Dan Percella and Jon Brachle believe trade at a discount to intrinsic value. This is a high-quality portfolio of US smaller companies on a lower valuation than the market, and the board has been buying shares back since early 2022 in response to the wider-than-average discount. As investment trust scrutineer Kepler observes, JPMorgan US Smaller Companies has a good long-term track record of outperforming the Russell 2000, having beaten the benchmark over five and 10 years with NAV total returns of circa 51% and 204% for those two periods compared to the benchmark’s 40% and 158%. Top 10 positions include the likes of workspace and portable storage solutions play WillScot (WSC:NASDAQ) and childcare and early education services provider Bright Horizons (BFAM:NYSE), not to mention tech solutions supplier Novanta (NOVT:NASDAQ), a play on the reshoring and deglobalisation theme, and RBC Bearings (RBC:NYSE), a ball-bearing manufacturer which, through the use of precision automation, competes in a market that often depends on lower wage economies. 

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