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The Wild West of U.S. smallcaps
The past decade has been that of the big U.S. stock market companies. They not only outperformed stock markets in the rest of the world, but also outperformed their smaller counterparts, the smallcaps, domestically. Still, those U.S. smallcaps remain an interesting and underexposed hunting ground for investors, where many hidden gems can be found.
In recent months, it seems as if only seven stock market companies - aptly named the Magnificent Seven - still matter to investors. Those seven, not coincidentally all large Amerta tech companies, drew all the attention to themselves and made investors forget that there is still a whole range of small- and medium-sized U.S. stock market companies, the small- and mid-caps, where there are also a lot of opportunities to be had.
At the top of fund specialist Morningstar's list of the best performing funds in that segment is the American Small & Mid Caps fund of Ghent-based asset manager Value Square. It posted a 35 percent return last year. With this, the relatively small Belgian asset manager outperformed its world-class peers such as Schroders, Robeco and BlackRock. Trends spoke with, among others, Jens Verbrugge, the manager of the Value Square fund, about the opportunities and pitfalls in U.S. small- and mid-caps.
New revival
The Russell 2000 is the benchmark index for that segment of the U.S. stock market. The large stock market companies, the largecaps, are represented in the Russell 1000 or the S&P500, the best-known U.S. index. The recent strong performance of the Russell 2000 versus the largecaps is a trend reversal from the period before (see chart Russell 2000 versus S&P500). "Between 2017 and March 2024, the Russell 2000 posted an annualized return (price appreciation plus dividends) of 7.5 percent. The S&P, led mainly by big tech, gained almost double that at 14.3 percent," says Jens Verbrugge. Moreover, ETFs tracking the S&P 500 saw record capital inflows last year.
But the roles have also been reversed before, "Between 1999 and 2016, the smallcap index posted an annual return of 7.4 percent, versus 4.5 percent for the S&P. Over that entire period, from 1999 to the present, they both put up virtually the same annual return," Verbrugge said.
Besides the insane stock market performance of the big tech companies over the past decade, there are other reasons why the U.S. small-cap index has lagged in recent years. "For example, last year's U.S. banking crisis hit a lot of rehional banks. These are well represented in the Russell 2000," says Jens Verbrugge, "as are listed real estate companies or REITs (real estate investment trusts). Those got it particularly tough recently. First because of covid, which hit shopping centers as well as office properties. Then the wave of inflation sent interest rates soaring, putting further pressure on real estate valuations."
Since last October, small stock market companies have been keeping almost pace with the S&P500 star index. "Fears of a recession in the United States were tempered around that time. That has played into the hands of smallcaps, as they are much more closely following the economic cycle. In addition, the prospects of the first interest rate cut have given smallcap prices an extra push, because they tend to have higher debt levels and interest rate cuts are good news for that," said Andrew Smith, the manager of a fund in small U.S. stock market companies at asset manager Columbia Threadneedle.
Meanwhile, expectations of Federal Reserve interest rate cuts have been scaled back. Late last year, analysts were still assuming six cuts this year. They have cut that down to three or even just two. So the question is whether the recent resurgence of small caps will be temporary.
Hidden pearls
Regardless of current market trends, the U.S. smallcap market offers many strengths that make it a fertile hunting ground for investors, says Jens Verbrugge. "It is much more liquid than, for example, the European small-cap market. In Europe, small companies often have very limited liquidity, making them de facto uninvestable. If something is going on, you're stuck in it."
Transparency and clarity are another asset. Verbrugge: "Every publicly traded company in the United States has to file standardized quarterly and annual reports. Everything is in English and in dollars. The political situation there is also easy to understand. All this makes that market very easy to follow up versus, say, Asia or even Europe. Just try following an analyst call from a small Chinese stock market company." That is not to say, however, that all of the market is equally attractive or buyable. "Smallcaps are pretty much the Wild West," argues Jens Verbrugge. "There are many quality companies, but just as many all kinds of companies with questionable business plans. There are empty stock market shells, cannabis stocks, biotech companies and so on. The whole meme thing is also happening in that segment of the market. More than 40 percent of the companies in the Russell 2000 were loss-making over the past twelve months."
Being such a motley crew also distorts the valuation of the small-cap index. "That is currently quoted on average at a price-to-earnings ratio of 23," Verbrugge calculates. You can call that relatively expensive, but the large group of loss-making companies skews that average. "Our fund is quoted at an average P/E ratio of 11," adds the Value Square analyst. Much more acceptable, in other words.
Passively playing the U.S. smallcap market with an ETF tracking the Russell 2000 is thus not the most appropriate strategy. Relative to the valuations of largecaps, U.S. smallcaps are currently trading at historically low levels (see chart Smallcaps historically valued lower than largecaps).
Diversity trumps
In addition to the junk, there are also a lot of underexposed strong companies or hidden gems among the small U.S. stock market companies. "That makes it a rewarding hunting ground to do individual stock selection or stock picking," argues Jens Verbrugge. "For one thing, it's a very spacious universe, which increases your chances of finding quality companies that the market is mispricing."
Much of that universe is also not on the radar of analysts and managers. "Smallcaps are much less followed by analysts. Unknown is unloved, so they are more likely to be undervalued. Coca-Cola Consolidated, for example, is the largest bottler in the United States. It turns several billion dollars in sales a year and there is not a single analyst following it." That underexposure can lead to fluctuations, though. "The price movements are not always logically explained. Sometimes a company comes out with solid results and the stock price still gets a pandering.
One example is the IT hardware company ePlus. After the fourth-quarter results, the share price fell 24 percent immediately after opening. By the end of the day the drop was still 12 percent and a week and a half later the stock was even several percent higher than before the publication of the figures," Jens Verbrugge says. The fluctuations make investors have to do their homework. "With such violent fluctuations, without anything fundamentally changing, the natural reflex is to start doubting. The firmer your analysis, the better you can respond to such price movements, because they also offer opportunities," says Verbrugge.
Growth is another asset of smallcaps. "In that segment, there are a lot of buy-and-build stories. The growth opportunities of small companies are greater than those of largecaps," Jens Verbrugge adds. "And then there's the chance of companies being acquired by private equity or by industry peers. That happens regularly, as in the case of Masonite, a market leader in door manufacturing, which was acquired by a competitor."
For European bellwether investors, U.S. smallcaps offer another specific asset. "They are much more focused on the domestic U.S. economy, where they get most of their sales. That allows you to respond to the local economy, whereas large listed companies are much more international and depend on ups and downs of the global economy," said Columbia Threadneedle's Andrew Smith. "For European investors, that diversification is an additional asset," adds Jens Verbrugge.
U.S. smallcaps...
Continue reading the article via Trends: https://trends.knack.be/geld/beleggen-2/het-wilde-westen-van-de-smallcaps-de-kansen-in-kleine-amerikaanse-beursbedrijven/
Disclaimer
- Source: Trends
- URL: https://trends.knack.be/geld/beleggen-2/het-wilde-westen-van-de-smallcaps-de-kansen-in-kleine-amerikaanse-beursbedrijven/
- Date: 11/04/2024
