In times of volatility investors often flee from smaller companies. They are deemed less safe than large multinationals. Look at the difference between the S&P500 and the Russell 2000 – a smaller companies index – and you will see this. Over the past six months (to 31st March) the S&P is up 8.5% (in sterling); the Russell 2000 is down around 3.3%.
Look at good small cap funds in the UK and US and you will see this pattern again. In times of crisis – this year, and March 2020, for example – they take a plunge. The market is indiscriminate when it is frightened.
Past performance is no guarantee of what may come, but historically, over the long term, good small-cap funds have often significantly outperformed their relevant small-cap index. Here is where the combination of time and active management can be its most powerful.
Since I launched my US small cap fund in October 2014 the Russell 2000 up 151%; the average IA North American Smaller Companies fund is up 183%. My fund is up 218%.
The big question investors should be asking themselves, then, is: “Do times of crisis and uncertainty create good buying opportunities for small-cap investors with a long-term horizon?”
Rationally speaking, small companies should be a good place for investors to find respite during periods of international uncertainty; with a bias towards the domestic economy, they are often protected from cross-border disruption and volatility. And US smaller companies come with the extra benefit of that domestic economy being the world’s largest.
In addition, the regulatory environment for start-ups is welcoming and American society is comfortable with risk-taking entrepreneurialism. It is a mindset that supports ambition and long-term growth – Mark Zuckerberg famously turned down a $1bn bid for Facebook from Yahoo. It is difficult to imagine founders in many other countries having the courage and belief in their potential value to walk away from such an offer.
Investment capital, meanwhile, is plentiful, with a huge pool of venture capital and, later, private equity funding competing for the best opportunities. And with invention so well-rewarded, invention becomes a constant.
For all these reasons and more, US smaller companies are often a happy hunting ground for discerning investors. But the current environment provides several good reasons to take a closer look right now.
Capital expenditure
There is an extraordinary boom in capital expenditure in the US currently. Capex by the large S&P 500 companies is now running 15% higher compared to a year ago, as businesses return to investment plans put aside during the worst of the Covid-19 crisis.
Much of that spending will end up boosting the revenues of US suppliers, often smaller companies, that provide the equipment and technology these businesses need for renewal.
AGCO, which owns the Massey Ferguson tractor brand, is just one example of a potential beneficiary of this trend. The last peak for capex in agriculture came as long ago as 2013 – and the average age of farming equipment across the US industry is now around 20 years. As commodity prices continue to rise, more money is flowing into US agriculture – this should support farmers’ willingness to make much-needed investment in the months ahead.
WillScot is another example of a portfolio holding poised to benefit from accelerated US capex. It specialises in providing customers with temporary space, recycling shipping containers to provide portable and additional accommodation in multiple industries, from mobile offices and storage centres to classrooms. As its customers invest in expansion and growth, WillScot should benefit from increased demand.
Mergers and acquisitions (M&A)
M&A activity in the US provides another driver of opportunity. It smashed records last year and is continuing in 2022 – with both corporate buyers and investors competing hard for targets. US smaller companies have found themselves at the receiving end of such bids.
Take Maravai Life Sciences, which provides a range of critical products that enable the development of drug therapies – including the reagents used to produce mRNA vaccines such as Pfizer’s and BioNTech’s Covid-19 inoculations. In February, it rejected an $11bn offer from the German supplier of laboratory equipment, Sartorius, that valued the company at a near 20% premium to its market price.
Telecoms and communications company Vonage, by contrast, accepted a bid for $6.2bn in November from Sweden’s Ericsson – a 28% premium to its pre-announcement share price.
Environmental, social and governance (ESG)
The rise of the ESG agenda is another potential fair wind for US smaller companies, with corporate customers and consumers alike increasingly looking for businesses able to offer greater sustainability.
Smaller companies such as Clean Harbors, which cleans up pollution and contamination on former industrial facilities offer a very direct play on ESG. But businesses such as Kornit Digital are also interesting in this regard.
Kornit is an Israeli-American digital textile printing businesses that helps the fashion industry – often criticised for using toxic materials and unsustainable manufacturing processes – to clean up its act. Its on-demand technology reduces the need for wasteful large production runs. It also uses eco-friendly inks and requires less water than traditional fabric printing.
Consumption
Elsewhere, we should not overlook the importance of the US consumer to smaller companies, with US consumption accelerating now that economic growth has bounced back from the pandemic. One
holding that stands to benefit here is Pool Corporation, the world’s largest wholesale distributor of swimming pool products – with discretionary spending on the rise, it is in prime position.
US smaller companies are not right for every investor – we each have different personal circumstances, investment goals and appetite for risk, and this is an area that requires thorough research. However, good funds can mitigate some of the risks by offering investors instant access to a broadly diversified portfolio of carefully chosen companies.
I asked at the beginning if times of crisis and uncertainty create good buying opportunities for small cap investors with a long-term horizon. I would conclude that, for many of us, they do.
Cormac Weldon is manager of the Artemis US Smaller Companies fund. The views expressed above should not be taken as investment advice.