America’s smaller companies lagged the wider US market in 2017. In fact, they have underperformed large-caps over the past five years. But their performance over 2018 to date has been far better. By the end of August, the Russell 2000 index had returned 14.3 per cent, versus 9.9 per cent from the S&P 500. Tax cuts have helped, as has the boom in the US economy. But is there more to come?
The US smaller companies market is larger and more liquid than many investors in the UK realise. By capitalisation, it is roughly the same size as the entire European equity market. And it is roughly twice the size of the UK.
Yet while it would be unusual for a UK-based investor to have no exposure to European equities, that is not the case for US smaller companies. There are more than 250 funds in the IA’s UK All Companies sector, 94 in the North America sector and 26 European Smaller Companies funds. But there are just 10 North American Smaller Companies funds.
Performance of indices over 5yrs in dollars
Source: FE Analytics
Clearly, this is an imprecise yardstick for measuring interest in an asset class. But this imbalance does suggest that a huge pool of potential investment opportunities is being overlooked.
How small is small?
In part, that neglect may stem from a tendency to underestimate not only the size of the US smaller companies market but also from a misunderstanding of the scale of the companies it contains.
Everything is bigger in America – even its smaller companies. If they were listed in London, some of our fund’s holdings – such as SVB Bank, Abiomed, E-Trade and Wellcare Group – would qualify for inclusion in the FTSE 100.
The Russell 2000 index, the benchmark for the US smaller companies market, includes stocks with a market capitalisation of up to $10bn. The average market capitalisation of the companies in our fund, meanwhile, is around $6.2bn. So by British standards, US small-caps are not that small.
Why now?
One of the attractions of US smaller companies today is that they give investors the opportunity to position themselves to benefit more directly from the economic dynamism of the US. Returns from the S&P 500 index, in contrast, tend to be dominated by large, global businesses for which America is just one, albeit important, market.
And while trade wars have been one of the most prominent concerns facing the US market this year, the domestic bias of US smaller companies means they will be less impacted by tariffs or restrictions on international trade.
Another positive: their domestic bias means they tend to be dollar earners, so are helped – rather than hurt – by the strength of the dollar. And they also tend to be the biggest beneficiaries of Trump’s tax cuts as, unlike America’s global giants, they didn’t preciously have the option of using their international operations to reduce their effective tax rates.
Other big attractions
Investing in smaller companies is not, however, simply a way of gaining more direct, more targeted exposure to the growing US economy, to the strong dollar or to the earnings boost from tax cuts.
The smaller companies market is richly blessed with innovative, rapidly growing companies. A combination of deep capital markets and entrepreneurial zeal makes the US a uniquely supportive environment for growth companies, with particular strength in industries such as technology, software and pharmaceuticals.
Another positive (for active managers such as Artemis) is that smaller companies tend to be less well covered by sell-side analysts than their larger peers, so instances of mispricing are more common.
Equity research by Wall Street firms is increasingly focussed on only the largest companies. The unbundling of execution from research has removed one incentive for banks and brokers to provide small-cap research.
In the past, they could look at their business holistically and see that they were attracting trading volume in the smaller companies that they were researching.
That doesn't happen today. So the analytical resource devoted to smaller companies is dwindling, increasing the inefficiencies for active managers to exploit.
When viewed from this side of the Atlantic, the opportunities that US smaller companies offer can be diminished by distance or simply overshadowed by their larger peers. But we hope the results of our active approach to investing in them are helping to make their attractions plain to see.
Cormac Weldon manages the Artemis US Smaller Companies and Artemis US Select funds. The views expressed above are his own and should not be taken as investment advice.