With the Thanksgiving holidays nearly here, beyond the festivities, it is a great time for reflection and to think about the upcoming year. When we reflect on how US smaller companies have fared recently, it’s been a mixed picture, but in many ways the recent choppier waters makes us even more excited about the opportunities ahead.
This year started under a cloud of negative sentiment for good reason: inflation was proving sticky and fears of an impending US recession dominated investors’ minds. Not only that, 2022 had seen the Russell 2000 shed a fifth of its value.
However, by the end of January 2023 the Russell 2000 had risen by 10%. This rally demonstrated the power of small-caps when valuations are favourable and when sentiment becomes more positive.
The banking sell-off in March, followed by the prospect of slowing global growth and higher-for-longer interest rates, led to a substantially negative view of smaller and mid-cap companies that was arguably not justified by the fundamentals.
This has left US small-cap valuations at historical lows relative to their large-cap peers. Today, we see relative valuations as one of the most compelling aspects of investing in US small-caps.
While we are cognisant that the earnings picture for small-caps is not poised for an immediate rebound and earnings have yet to hit bottom, over the intermediate and long term we believe that the stocks will react positively.
From an economic cycle perspective, US small-caps have typically surpassed their larger peers in the performance stakes towards the end of the recession phase. For example, in the 10 years following the tech bubble, the Russell 2000 outperformed the Russell 1000 eight times out of 10 calendar years and by over 400 basis points per year on average. This is because these smaller companies are anticipated to benefit from the recovery in corporate profitability and US economic growth.
US small-caps are more sensitive to lower interest rates and tightening in credit spreads as they tend to be more leveraged than their larger counterparts. While it is true that the S&P 500 has outperformed the Russell 2000 over the past 10 years, this outperformance has been driven by some of the highest concentration that we have ever seen in mega-cap tech – FAANGs or the ‘Magnificent Seven’.
Looking ahead, we expect macro factors will continue to dominate investor focus over the short term but we believe our process can outperform over the cycle. While the market seems fixated on whether the US will have a recession or not, we remain balanced and continue to monitor incremental risks that could represent headwinds for US equities more broadly.
Through the volatility, we continue to focus on high conviction stocks and take advantage of market dislocations for compelling stock selection opportunities.
We are looking to find the best, innovative companies in the small cap sphere that serve market niches, with higher earnings growth and higher potential returns. Many of these small but quality companies are less researched. The average small-cap name has five or six analysts, whereas for large-caps this could be double.
For us, attractive investment ideas across the small-cap market have universal attributes: they showcase quality, good management and consistency of earnings even in times of inflationary pressure. As we go into 2024, resilience across these dimensions will be key.
Jonathan Brachle is manager of JPMorgan US Smaller Companies Investment Trust. The views expressed above should not be taken as investment advice.