Sizing up US smaller companies

There is a strong case for considering an allocation to US small-cap stocks in most investors’ portfolios. Small-caps offer diversification from their large cap peers; with different characteristics in terms of volatility and different drivers of performance helping to reduce their correlation to large-caps, as well as in many cases offering exposure to sectors from which their larger peers are absent.

Now, with vaccinations rolling out in America at pace and pandemic restrictions being widely rolled back, the US economy is experiencing something of a turbo boost in its recovery, recording its second-strongest expansion since 2003 in the first quarter of this year. Small-caps, which are generally more domestically oriented, are particularly benefitting.

With fiscal stimulus and government support likely to continue for some time into the future, the outlook is strong for the sector.

Solving a problem like small-caps

However, with the US small-cap benchmark containing over 2000 companies, selecting the manager through which to tap into this opportunity set can be challenging. One issue is that both the dynamics of the US economy and the underlying companies are less familiar to UK investors. At the same time, the sector itself is harder to invest in. On average, each company in the Russell 2000 Index is covered by 5.6 analysts, while those in the S&P500 are covered by 20.6 according to Furey Research. Investors seeking exposure to US small-caps, therefore, have far less information at their fingertips when it comes to choosing the right investment – making it much harder to identify winning stocks.  

With this in mind, careful selection of both a manager and firm with deep experience in this sector is crucial to gaining the informational advantage that might lead to success.

Knowledge is power

One manager which fits this description, newly accessible to UK investment trust investors, is Brown Advisory. The firm was recently appointed manager of Brown Advisory US Smaller Companies (BASC), an investment trust previously under the stewardship of Jupiter Asset Management.

There are several reasons the trust’s board put its faith in Brown Advisory, most notably the firm’s rich history of investing in this space. It has been active in US small-caps since the early 1990s, meaning small-cap investing is woven into the culture of the firm.

The trust’s named manager, Chris Berrier, has been running the Brown Advisory US small-cap growth strategy since 2006 and an equivalent open-ended UCITS fund since 2007, with demonstrable success – the fund has outperformed both the Russell 2000 Growth and Russell 2000 on a per annum basis since Chris took over 15 years ago. Total assets managed by Chris in the small-cap growth strategy now stand at $7.6bn.

A key aspect of this success has been the size and structure of the team around Chris, who has been supported by associate portfolio manager, George Sakellaris since 2014. The pair have access to a large bank of analysts which gives Brown Advisory significant coverage of the US small-cap space.

This strength in depth means that the equity research team is able to conduct around 500 meetings with small-cap companies per year, speaking to management and visiting operating sites, from an investable universe of around 2000 companies.

Panning for gold

Another aspect of the Brown Advisory culture which gives the team additional informational firepower is the firm’s private equity expertise. Other parts of the Brown Advisory business create customised portfolios for high net worth clients and charities, which can include private equity, meaning that the business has this particular experience in-house.

This private equity ‘lens’ can be crucial when assessing the operations of shortlisted businesses, such as providing sectoral context, and for offering additional insight into companies newly joining the listed small-cap arena, through for instance the IPO process.  

The pace of new entrants coming to the market through IPOs, and the recently popular special purpose acquisition companies (SPACs), has reached historic levels in the last year or two. While that trendiness warrants selectivity, it has created a flurry of new opportunities for the strategy, with its investment team participating in twelve IPOs over the last two years (investing via the open-ended strategy initially).

One example is Phreesia, a company that Brown Advisory had been aware of for several years while it was private, due to its network of venture capital and private equity contacts. When Phreesia, which provides patient check-in software for medical practices, came to market, this meant Brown Advisory was already aware of its competitive strengths and profile, and so could participate with some confidence.

Small but mighty

With all these factors combined, Brown Advisory’s access to additional information and insights about smaller companies lends itself to a portfolio that is highly differentiated from its peers. It typically has an active share of over 90%, meaning it is constructed differently to its benchmark, and the open-ended strategy has a strong track record of generating alpha – returns in excess of the benchmark – as a result of rigorous stock selection.

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