The Russell 2000 – the most popular performance measure for the market – has a strong record over the short-, medium and long-term, outpacing the S&P 500 over one, three, five and 10 years. Over three years the index has managed 64.63 per cent, putting it ahead of almost every recognisable index in the developed or emerging equity universe.
Performance of indices over 3yrs
Source: FE Analytics
It has also consistently beaten the MSCI AC World index, the MSCI AC World Small Cap index and its UK equivalent – the FTSE Small Cap index – over these time periods.
Unsurprisingly, this has resulted in strong performance from open- and closed-ended funds investing in the asset class. North American small cap funds and investment trusts are among the most consistent of recent years, generally at least doubling investors’ money over 10 years.
However, for anyone worried that they have missed the boat, manager of the JPMorgan US Smaller Companies IT Don San Jose says that there remains a strong case for the asset class.
The manager points out that the US small cap market is the best way of getting direct exposure to the US domestic market, which is benefiting most from the US recovery story.
"What is really interesting about US smaller companies at the moment is that they are such a play on the domestic market," he explained.
"The Russell 2000 index derives about 80 per cent of its earnings from the US market, led by the housing, auto and consumer industries."
"The S&P 500 gets 35 per cent of its earnings from overseas compared with the Russell 2000’s 20 per cent, so it’s definitely more of a domestic play."
He says his ability to get direct access to the US housing market, which has been earmarked as one of the biggest drivers of the US’s recovery in recent months, is particularly appealing.
The sector has already performed well, but the manager thinks this story has further to go.
"Housing-related stocks in the US account for between 18 and 20 per cent of the Russell 2000’s earnings," he explained. "Prices are going up, starts are going up and affordability is still good. This, combined with a recovering consumer, is really positive."
"We’ve had yet more positive [payroll] data out last week and the consumer is feeling a lot better."
San Jose does accept, however, that the US small cap market is far from cheap – unsurprisingly, given how strongly it has performed in recent months and years.
"Valuations are perhaps one cause of concern," he explained. "The small cap market is trading at 19 times on a price/earnings basis, compared with 16 times from the large cap market. This is a larger spread than it has been compared with history – one standard deviation away from the norm."
"It does make it harder to find new ideas. Our gearing has typically been between 5 and 8 per cent and it is at the lower end at the moment and the cash is a little higher than it has been."
However, he says the size of his universe enables him to find pockets of value, particularly as many of the stocks are under-researched.
"The reason for investing in US small caps is exactly the same as the UK – it is about finding companies with higher earnings growth and higher potential returns and added to this is the fact that many of them are very under-researched," San Jose said.
"The average small cap has five or six analysts versus double that for large caps, and many of the names I own are covered by less than three."
"This gives us the ability to have an edge and find opportunities that are misunderstood."
San Jose says he would welcome a pull-back in the market so that he can buy his favourite companies at a cheaper price, but is still confident that he can make strong returns over the next decade.
"Over the next 10 years, you’ll see a similar dynamic to what we’ve seen – you just won’t make as much when you’re buying at 19 times compared with 12 times," he added.
The JP Morgan US Smaller Companies trust has five FE Crowns – the maximum score – thanks to its strong risk-adjusted performance in the short-, medium- and long-term.
FE Analytics data shows that the trust has beaten the Russell 2000 and the IT North American US Smaller Companies sector average over one, three, five and 10 years. It has returned more than 100 per cent over three-, five- and 10-year periods – the only trust to have done so in its sector.
Performance of trust, sector and index
| Name | 1yr returns (%) |
3yr returns (%) | 5yr returns (%) | 10yr returns (%) |
|---|---|---|---|---|
| JPMorgan US Smaller Companies IT |
47.81 | 105.36 | 98.63 | 150.59 |
| Russell 2000 | 28.42 | 66.09 | 73.98 | 130.61 |
| IT North American Smaller Companies |
32.01 | 42.66 | 57.43 | 107.99 |
Source: FE Analytics
San Jose explains that handling downside risk is a very important part of his process.
"Two things add to volatility – the poor liquidity in small caps and high expectations," he said. "Higher expectations in small caps have caused the multiple expansion we’ve seen of late."
"We go through the portfolio on a name-by-name basis and put smaller amounts in those which are affected by either of the two factors."
"In general, we look at companies with stable earnings and good cash-flow. This tends to mean we have a lower beta than the market and can underperform in steep up markets, but it has worked for us overall."
San Jose has run the £78m trust since May 2009 and confirmed no company in the portfolio has defaulted under his management. He says most small cap companies have learnt their lesson from the 2008 financial crisis, which has left many with very strong balance sheets.
In general, he says he avoids leveraged companies because "too much debt really hurts companies on the downside".
"We like to err on the side of caution," he said.
The manager also looks to minimise volatility by ensuring that one stock does not dominate the portfolio. No single company currently has more than a 3 per cent weighting and the top-10 accounts for only a fifth of assets overall.
San Jose says he only buys small caps, which he defines as businesses with a market cap of between $500m and $3bn. He explains some stretch that definition to $3.5bn. From time to time he does hold on to companies that have grown into mid caps.
Consumer discretionary is currently the manager’s biggest overweight, which he says gives him direct exposure to the end domestic market. Top-10 holdings include clothing franchise American Eagle Outfitters.
JP Morgan US Smaller Companies has ongoing charges of 1.69 per cent, but does have a performance fee on top of that. It is currently on a slight premium of 1.2 per cent.
