Disclosure – Non-Independent Marketing Communication
This is a non-independent marketing communication commissioned by Brown Advisory US Smaller Companies. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.
Small caps have been particularly hard hit by the mix of geopolitical and economic problems we’ve seen so far this year. With the prospect of rising rates has come a dampened appetite for companies trading at higher valuations. Paying a higher price, the logic goes, makes sense if the cost of capital is low. If that changes then market participants are less willing to pay those sorts of premiums.
There is some sense to this but it’s also not necessarily a nuanced view to take. The US is a highly innovative economy and within that, the small cap universe is broad and under-served which can lead to great opportunities compared to large-caps. Just as with their larger peers, some companies are better placed to deal with the current macroeconomic headwinds than others. The range of valuations is also wide – not all companies trade at massive multiples relative to their earnings.
Investment trusts that focus on small caps reflect the diverse range of businesses that are on offer. While some may have been happy to fund more speculative companies trading at high valuations, others have not. But looking at share prices or net asset values (NAVs), it is a struggle to say which is which, given that both have been hard hit.
Brown Advisory US Smaller Companies (BASC) has a focus on quality companies. As a result, portfolio managers Chris Berrier and George Sakellaris have tended to steer clear of early-stage, speculative businesses.
In practice this often means avoiding firms that are yet to make a profit. It also means the managers have historically not invested in certain biotech or medical companies, which typically make up a big proportion of their investable universe. These firms may not earn anything and may also have valuations that are heavily dependent on the outcome of drug trials and regulatory approvals, both of which are notoriously hard to predict.
All of this may sound sensible, but there are times when it can be a hard case to make. For instance, companies in the US small cap universe that had no earnings actually outperformed their profitable peers in 2020.
That reflected a period of overexuberance – a bubble, according to some – that has almost certainly come to an end. It also represents something of a return to normal as profitable small caps have historically delivered superior long-term returns relative to their unprofitable peers.
BASC has not been immune from the resulting sell-offs but it has fared much better than it would have done, had it been invested in those more speculative businesses. The trust’s share price has also widened significantly relative to its NAV. In January, BASC was trading at a small premium but that’s changed to a discount, which stood at 14.3% on 13/07/2022.
That could reflect some of the selling we’ve seen in the wider market, where share prices appear to have fallen without much regard for the underlying businesses. For instance, BASC’s holding Genpact has continued a long track record of profit and revenue growth so far this year but has still seen a decline in its valuation over the same period.
Genpact is arguably a good example of the characteristics that Chris and George look for when making investments. The pair try to identify firms which have what they call ‘3G’ qualities – durable growth, sound governance, and scalable go-to-market strategies.
It’s a strategy that has paid off historically. Although they only took over management of the trust in 2021, Chris has run his small-cap strategy since April 2006, including an open-ended UCITS fund since 2007. In that time the fund has delivered meaningful outperformance of both the Russell 2000 Growth Index and the Russell 2000 Index, the latter of which is BASC’s benchmark.
Quality companies in that portfolio tended to perform better than others during the last major recession in the late 2000s. History isn’t a guide to future outcomes but it is hard to see how the more robust fundamentals that BASC’s managers look for would not be superior in the current macroeconomic environment, compared to firms that don’t have any earnings.
The managers have also taken advantage of the volatility we’ve seen in markets so far this year by adding to the portfolio. They’re paying particular attention to firms’ defensive qualities, which will help them survive a tougher economic environment.
This includes companies in tech and healthcare that have been able to cut spending but still yield good results, particularly those active in certain niches, like cybersecurity, that look less likely to be affected by spending cuts.
Any purchases are unlikely to produce quick fixes or result in rapid gains. But as Chris’ track record shows, quality has a tendency to win out in the end. And in a period of uncertainty they’re also the sorts of businesses most investors look to hold.
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