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Jo Groves
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Updated 14 May 2024
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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.

Patience is a virtue and this is undoubtedly the case for investors in US small-caps over the last few years. There’s been a notable divergence in trajectories with the US mega-caps soaring into the stratosphere while their small-cap peers have struggled to keep pace. But, as the saying goes, all good things come to those who wait, so is it time for US small-caps to shine once more?

Putting this into some context, it’s been 692 days (and counting) for the small-cap Russell 2000 Index to regain its previous high after the trough in mid-2022. This is longer than the peak-to-trough recovery period for the stock market crash of the dot.com era and closing in on the global financial crisis. Granted that geopolitical and macroeconomic issues have been somewhat of a headwind for small-caps over the last two years but the current period of underperformance looks anomalous relative to the global shockwaves caused by the latter.

That said, investors keeping their heads when others are losing theirs are often handsomely rewarded (to plagiarise the words of Rudyard Kipling). Small-caps have a long history of outperforming their larger-cap peers and, with the macroeconomic backdrop looking more benevolent, the turning point may well be coming into view.

A track record of outperformance

It’s widely accepted that small-caps will typically outperform large-caps over time due to their superior growth potential and US equities are no exception. The Russell 2000 Index has delivered a 25-year cumulative total return of almost 570% (from 1998 to 2023), outpacing even the high-growth S&P 500 return of c. 520%. This is no mean feat given the stellar returns of the S&P 500 in recent years.

However, given the volatility over shorter time periods, small-cap investors would do well to heed this advice from Warren Buffett: “If you aren't thinking about owning a stock for ten years, don't even think about owning it for ten minutes.”

The chart below shows the relative outperformance of small-cap and large-cap US equities over different time periods in the last century. While US small-caps have outperformed 55% of the time over a five-year horizon, this rises to 96% for 30 years, proving the value of ‘time in’ rather than ‘timing’ the market.

As mentioned earlier, the macroeconomic environment has undoubtedly been challenging for US small-caps but, despite these headwinds, the Russell 2000 Index bounced back from a 20% negative total return in 2022 to reward investors with a positive return of 17% in 2023.

History also shows that investors keeping the faith through downturns have often reaped attractive returns in the subsequent recovery period. The graph below highlights that US small-caps have performed particularly strongly in the two years following negative returns, with the Russell 2000 Index delivering cumulative total returns of 66% and 54% respectively in the two calendar years following the stock market crashes in 2002 and 2008.

As an aside, it’s interesting to note that the Russell 2000 was more resilient than the S&P 500 during the first two crashes, falling by a lower amount as well as delivering higher subsequent returns. The US large-cap sector has also become heavily dependent on the performance of the magnificent seven, with the four largest US companies by market cap exceeding the total value of the Russell 2000 Index.  

Why it pays to be picky

Given the cyclical nature of equities, it can be challenging for investors to position their portfolios to protect against the downturns and capitalise on the upturns. However, active managers can offer investors the opportunity to generate superior returns throughout the cycle.

Christopher Berrier, manager of Brown Advisory Smaller Companies (BASC), summed up the advantages of active management in his recent review: “The ability to be flexible and adaptable is one of the most important pieces of our investment process. Perhaps the Goldilocks thesis of a solid economy, markedly lower inflation, and lower interest rates that emerged in December will hold, but perhaps it will not. Our goal remains to drive attractive risk-adjusted returns over a full market cycle.”

BASC offers an ‘all-weather’ portfolio of around 80 small and mid-cap quality companies with low leverage, attractive returns on capital and superior growth potential. From a risk perspective, it’s also worth noting that the small and mid-cap sector encompasses far larger companies than in the UK: the weighted average market cap of BASC’s portfolio companies is over $8bn, which would comfortably qualify for inclusion in the large-cap FTSE 100 Index in the UK.

Christopher adjusts sector allocations to manage downside risk for investors and reduced the trust’s exposure to cyclical sectors last year due to macroeconomic uncertainty. This sector weighting is combined with stock-specific attributes, with a particular focus on profitability. This leads to a high active share given that 40% of the Russell 2000 companies are currently loss-making.

BASC remains overweight healthcare and technology due to their attractive growth potential. The biotech sector also continues to see a high level of M&A activity as the pharma giants deploy their significant war chests to acquire highly innovative biotech companies.

BASC recently benefited from the c. 50% acquisition premium paid by Bristol Myers Squibb for portfolio company Karuna Therapeutics. It has also invested in Neurocrine Biosciences which has FDA-approved treatments for tardive dyskinesia and Huntington’s disease chorea.

Opportunity knocks

The US small-cap universe is a fertile hunting ground for stock-pickers, offering over 2,000 companies across a wide range of sectors. It’s also an under-researched sector: on average, only 5 analysts cover the companies in the Russell 2000 compared to 18 for the S&P 500, according to Furey Research Partners.

While a lack of research can present a barrier to retail investors, it enables active managers to add alpha by leveraging in-house resources to exploit pricing inefficiencies. Chris is supported by a robust equity research team at Brown Advisory, providing a strong pipeline of ideas generation, and in-depth knowledge of the companies and management teams in which they invest. This is a differentiating factor given the experience and expertise of management teams in the small-cap sector can vary widely.

Valuations also remain attractive, with the Russell 2000 Index trading on a forward price-earnings ratio of 26, compared to a 10-year average of 37 (as at 01/05/2024). BASC recently added industrial companies Enpro and SPX Technologies to the portfolio due to their subdued valuations. In the case of Enpro, Christopher perceived that the current valuation didn’t reflect its high-quality portfolio and secular growth drivers in the semiconductor market.  

Looking ahead, if macroeconomic conditions continue to improve, the return of investor appetite for US small-caps could provide the final catalyst for a sustained period of outperformance. In the meantime, history shows that investors playing the long game have been suitably rewarded when the spotlight invariably shifts to small-caps.

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