Not only could US small-caps continue to outperform their larger peers over the coming months, but they may also be safer bets given the current investment backdrop, according to Artemis Investment Management’s Cormac Weldon.
Small-caps globally have beaten their larger peers over the past decade, as the below chart shows, as markets rallied following the global financial crisis fuelled by more accommodative central bank policies.
Weldon – head of Artemis US equities team and manager of the £497.7m Artemis US Smaller Companies fund – said positive momentum suggests that the growth in US small-caps could still have room to run.
So far this year, funds investing in North American smaller companies have performed strongly as the wider US economy has continued to accelerate.
The strong support for the US market and the growth style has been reflected in a 15.58 per cent gain for the IA North American Smaller Companies sector, in line with the US small-cap benchmark Russell 200 index.
Performance of sector vs index YTD
Source: FE Analytics
According to Weldon, a number of secular trends in financial markets are affecting investors in smaller companies.
The first trend is the decline of research focused on small-cap companies. This decline, he said, is creating inefficiency in pricing and, as a result, generating opportunities for active investors.
“These days, research activity by Wall Street firms is increasingly driven by the demands of banking and equity trading,” he explained.
“To a large extent, this leads analysts to focus on researching very large companies. At the same time, the unbundling of execution from research is putting pressure on smaller research houses, which is leading to a decrease in research of small-caps.”
Another trend benefitting smaller businesses in the US is the growth in passive investing. This, he said, has driven money into the most liquid parts of the market and out of less liquid areas – including smaller companies – which presents opportunities.
According to the veteran fund manager, US president Donald Trump’s economic policies are also acting as tailwinds for those US companies that sit at the bottom of the capitalisation spectrum.
“They are the biggest beneficiaries of Trump’s tax cuts as they were paying the headline tax rates with [unlike larger companies] no way to reduce them through international operations,” the Artemis manager noted.
In the fund manager’s words, the tax cut/capital expenditure incentives have also “barely begun to be recognised”, which shows his confidence in the longevity of the economic cycle.
“We believe that this cycle has years, rather than months, to run yet,” he added.
If that is the case, Weldon said domestic companies should have the wherewithal to reinvest to grow their businesses.
However, if they choose not to do that, they can engage in M&A activity, which he noted will also benefit smaller companies.
The Artemis US Smaller Companies manager said the current backdrop also favours smaller companies, which means this is a good time to invest in those smaller North American businesses.
US vs OECD GDP growth
Source: OECD
“As one of Trump’s pledges was to cut red tape, small-caps stand to profit disproportionately from a more relaxed regulatory environment. And further to my point about corporate activity, a less strict regulatory environment would encourage more M&A,” he said.
Given overall concerns about the impact of a potential trade war, as the manager noted, given that small-caps have more domestic exposure, these will also be less impacted by tariffs or trading restrictions.
“The domestic exposure also makes them more geared to strong US GDP growth, which will in turn lead to small-caps producing higher revenue growth as they typically do so in an accelerating economy,” he pointed out.
Furthermore, US small-caps are dollar earners, which makes them less vulnerable to dollar strength, he noted.
The distinctive characteristics of these business – quite different to their peers in other developed markets such as Europe or the UK – are also good reasons for investors to pay closer attention to these stocks.
“The US smaller companies market is larger and more liquid than many investors in the UK realise,” he said. “By capitalisation, it is roughly the same size as the entire European equity market. And it is roughly twice the size of the UK.
“US small-caps are also not small by European standards: the Russell 2000 index, the benchmark for the US smaller companies market, includes stocks with a market capitalisation of up to $10bn.”
He added: “These companies benefit directly from the size and dynamism of the US economy and the deep pool of venture capital available to fund innovative ideas.
“If an idea becomes a product that has a competitive advantage, the company that invented it often comes to the US public market relatively quickly, at which point we can invest.
“That company then has the largest economy in the world as its home market. It can build scale and profitability and perhaps at a later date launch internationally, with the backing of a large profitable domestic market.”
Performance of fund vs sector & benchmark under Weldon
Source: FE Analytics
Since launch of the fund in 2014, the Artemis US Smaller Companies fund has delivered a 138.16 per cent total return compared with a 94.74 per cent gain for the average IA North American Smaller Companies fund and a gain of 95.07 per cent for the Russell 2000 index. It has an ongoing charges figure (OCF) of 0.87 per cent.