A bigger slice of pecan pie

Veteran fund manager Sir John Templeton is quoted as saying: “The only investors that don’t need to diversify are those that are right 100% of the time.” Given that most of us aren’t (unfortunately) in this category, diversification seems a sensible strategy, not only as a way of mitigating losses but also improving the odds of backing some winners. With the luxury of hindsight, one such winner is undeniably US large-cap equities which have delivered stellar gains for investors over the last decade.

But (oxymorons aside) this is old news. Indeed, I suspect that if you asked a hundred investors whether their diversification strategy includes exposure to the US, you’d be able to count the ‘nays’ on one hand. What may come as more of a surprise, however, is that the average UK retail investor may still be underweight the US.

Recent research by the AIC revealed that the average UK equity investor has allocated just over 30% of their portfolio to North America (of which the US takes the lion’s share) and 20% to the UK. Yet on a value basis, US equities currently account for over 40% of global equities, compared to a rather more modest 3% share for the UK (according to the latest data from SIFMA).

That said, portfolio diversification should be focused on growth prospects rather than a simple allocation by relative value, so what about target allocations? Well, the PIMFA weightings for UK investors seeking capital growth includes an allocation to US equities ranging from 36% to 63%. Similarly, Hargreaves Lansdown’s ‘moderately adventurous’ fund has a North American weighting of almost 50%. These all point to one conclusion: UK investors may want to revisit their US allocations.

As tempting as it is to take the Route One approach of buying a S&P 500 tracker (or similar), the dominance of the ‘magnificent seven’ in market-cap weighted indices may result in concentration rather than diversification. This is illustrated by the market capitalisation of the top three US companies currently surpassing the total value of the Russell 2000 by some margin. As a result, investors may wish to broaden their net when looking for a core US allocation, both in terms of sector and market capitalisation.

One such option is Brown Advisory Smaller Companies (BASC) which views the US small-cap sector as a fertile hunting ground, characterised by a large investable universe of more than 2,000 companies that can be overlooked due to a lack of analyst coverage. The US small-cap sector has a track record of outperforming its larger-cap peers over the longer-term and offers an impressive breadth of sectors compared to the concentration in the large-cap market.

Bargin hunting

The valuations of large and small-caps have notably diverged over the last three years, leaving the small-cap S&P 600 trading on a forward price-earnings ratio of 14.5x, considerably below the 20.0x of the large-cap S&P 500 (according to Yardeni, as at 02/02/2024).

It has undoubtedly been a tough macroeconomic backdrop for small-caps, with investor sentiment deteriorating on the back of rising inflation and general market volatility. However, as my colleague recently noted, historical data shows that smaller companies perform well in absolute terms when inflation and interest rates start to fall from their peak, particularly where inflation has peaked above 3%. The hoped-for reversal in these economic headwinds and improving investor sentiment could therefore be positive for future returns.

Manager Chris Berrier views depressed valuations as an appealing opportunity for an actively-managed fund such as BASC. An influx of passive capital into the small-cap sector has helped to prop up lower-quality companies but Chris believes that an active approach will reap the rewards of discriminating between the winners and the also-rans. These higher quality businesses offer a long runway to growth and the potential to significantly outperform their peers.

However, a key challenge of small-cap investing is narrowing down the large investable universe of companies. BASC benefits from the input of a dedicated group of sector analysts focused on identifying potential opportunities, in addition to the wider Brown Advisory equity research team. Chris then applies his ‘3G’ investment filter to identify those companies with durable growth, sound governance and a scalable go-to-market strategy.

Due to attractive valuations, Chris has added a number of companies to the portfolio over the last year. BASC is currently overweight the healthcare sector, while its industrial holdings should benefit from a hardening in the trend towards ‘re-shoring’ of supply chains in light of continued geopolitical tension.

Managing downside risk

Another benefit of active management is the ability to manage downside risk. For this reason, Chris focuses on the larger end of the sector, which is less dependent on the vagaries of investor sentiment. It’s also worth noting that the US small-cap sector encompasses significantly larger businesses than the UK, with market caps typically ranging from $300 million to several billion (compared to £50 to £300 million in the UK).

BASC focuses on ‘all weather’ high-quality companies offering above-average growth prospects, a higher return on capital and lower debt. This quality bias means that portfolio companies should be more resilient in times of economic stress, supporting returns through the full cycle. Chris tends to avoid interest-rate sensitive sectors such as financials and real estate, and more speculative, loss-making businesses.

Looking ahead, there is no guarantee of success but BASC remains well-placed to benefit from a re-rating in the small-cap valuations if macroeconomic challenges ease and capital moves away from the ‘magnificent seven’ in the hunt for diversification. The current discount of 15.5% (as at 04/02/2024) may also represent an attractive entry point for investors to increase their allocation to US equities.

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