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.
What do Apple, Amazon and Microsoft have in common? At IPO all three would have counted as US small caps by today’s standards. Now, they are among the largest companies by market capitalisation in the world. While for every Apple or Amazon there is a small cap firm that didn’t hit the big time, these examples demonstrate the huge potential for growth present in smaller cap companies if you can identify the winners.
Yet, many investors remain under allocated to this market segment (or with no allocation at all). Several common perceptions contribute to this dynamic: that smaller cap companies are not worth the volatility trade off or that growth is now easily attainable among mega-cap companies, rendering the return potential of small caps void relative to the risk being taken.
History provides a useful playbook for investors looking at US smaller companies. By understanding the specific characteristics of this market, and how the broader market treats it, investors can gain a better appreciation of the opportunities and challenges that lie within.
Mind the valuation gap
Over the long term, US small caps have outperformed their large cap peers the majority of the time. However, there is some marked cyclicality to this performance – and in recent years large caps have had the upper hand.
Indeed, small caps have underperformed their large cap peers for much of the last half decade. As a result, the valuation gap between the two segments is considerable, with small caps at a significant discount. In previous cycles, notably the late 1970s and following the dot-com crash in the early 2000s, small caps have outperformed after a sustained period of low valuations. Given that the valuation gap between small and large US companies is historically wide, this gives some pause for thought.
Further substantiating the current case for US small caps is the broader economic and macroeconomic context. Recent unemployment and wage data has the majority of market observers predicting that the Federal Reserve will halt, and then reverse, the rate rises of the last two years, long cited as a headwind for small caps.
At the same time, the trend for bringing business operations back onshore – heavily incentivized by federal and state governments – should benefit a wide cohort of small caps that provide business support services, industrial technologies and operational hardware. Similarly, the move towards reducing the impact of operations should benefit those smaller businesses that have developed a host of solutions to tackle the climate challenge.
It is these kinds of longer-term trends that the innovative products and services of smaller cap companies are often the best-placed to address. Hence why some of the biggest names in global markets are innovative technology companies, less than 50 years old, that were once small caps.
Not so small
While every economy has “small caps”, this does not mean the same thing universally. True, when looking at small caps you are looking at the smallest businesses within an economy. But, thanks in large part to being the largest economy in the world by some measure, US small caps look very different to their peers in other countries.
Notably, they are defined as businesses with a market capitalisation of around $6-7bn or less. This would place many of them firmly within the FTSE 100 in the UK. Which demonstrates a point – that these are by no means start up fledglings, struggling to make a profit. Instead, many of them are established, often multinational, businesses with clear market niches.
Indeed, when the now-mega cap stocks we discussed previously floated, they were already profitable market leaders within their segments.
One of the defining features of the small-cap universe is that, with over 2,000 constituents, it contains a wide range of companies. Many of these do not have comparative peers in the large-cap universe. For some, this is because they operate in a mature but specialized niche, for example regional banks or specific industrial technologies. Elsewhere, this is due to the truly innovative nature of these businesses, including biotechnology developers and software designers.
As a result, investors in this segment of the market can access growth potential that simply isn’t replicable in other indices. This comes on two fronts: the first is growing demand for a company’s products and services, for example cloud-computing solutions where this market is ever expanding in an increasingly virtual world. The second is the potential for acquisition, with innovative smaller businesses targets for large-cap peers looking to diversify or consolidate their operations in a market.
Investing in US Smaller Companies with investment trusts
The advantages of investing in US smaller companies with investment trusts are myriad. Most notably, given the 2,000+ company universe and the geographical diversity across the US, market expertise can be invaluable.
This includes having analysts on the ground, deep experience within the market and strong networks within the US in order to garner strong informational advantages and insights that can be the decisive factor when investing.
Also important is experience investing within this specific market segment. The idiosyncrasies of small caps mean that the response to economic and macroeconomic factors can be dramatic and unexpected, due partly to leverage levels, subsector or even regional exposure.
Within the investment trust universe, only two trusts currently invest solely in US smaller companies. At the time of writing (November ’23) both have been sitting on significant discounts for some time, and have an average ongoing charge of 0.96%.
Case study: Brown Advisory US Smaller Companies (BASC)
Company: Brown Advisory
Managers: Christopher A Berrier; George J Sakellaris
Ongoing charges: 0.97% as at 31/12/2022 (source: BASC interim report)
Dividend policy: None
Benchmark: Russell 2000 TR Index
One of the two constituents of the AIC’s North American Smaller companies sector, Brown Advisory US Smaller Companies (BASC) is undergoing a period of transformation following the takeover by Brown Advisory of the trust’s management from Jupiter Asset Management in April 2021.
This takeover led to the implementation of a strategy that closely mirrors one successfully applied by Brown Advisory to US smaller companies in an open-ended structure for several years.
The focus is explicitly on quality growth companies, following the management team’s ‘three G’s’ principle: they look for companies that exhibit durable growth, sound governance and scalable go-to-market strategies.
As a result of this focused approach, the trust exhibits a high active share relative to the market and its concentration on growth potential (albeit with risk mitigations in place) means that it has a tilt towards some more growth-oriented sectors. The management team uses carefully-controlled allocation sizes to mitigate some of the risks associated with this approach and the asset class as a whole.
1) What is the investment trust’s goal?
The investment trust aims to achieve long-term capital growth by investing in a diversified portfolio primarily of quoted US smaller and medium-sized companies.
2) What kind of stocks do the managers like?
The investment trust is managed with a total return rather than a style mindset. The investment trust managers try to provide a balanced portfolio of undervalued companies, which they believe will deliver returns of 10% p.a. There is no guarantee they’ll achieve those returns and the investment process may change in the future.
3) Are investment decisions driven by a particular investment style?
The trust’s decisions are driven by the team’s ‘three g’s’ mantra: looking for durable growth, sound governance and scalable go-to-market strategies. As a result, the trust has a lean toward growth stocks, although it is not an explicitly “growth” strategy.
4) How many stocks does the investment trust typically hold?
The investment trust tends to hold around 80 stocks.
5) What is the investment trust’s dividend policy?
The investment trust does not pay a dividend unless obliged to comply with UK rules.
6) What are the investment trust’s ongoing charges?
The investment trust’s ongoing charges including annual management fee are 0.97% at the time of publication. Note this is subject to change.
7) Does the investment trust have performance fees?
The investment trust does not have performance fees. The portfolio managers are also invested in the company, so their interests are aligned to shareholders.
8) How much attention do the managers pay to their benchmark, and to what extent are absolute returns important?
The investment trust places a heavy emphasis on delivering total returns to shareholders. Although the benchmark is useful for gauging performance, it is not a driver of investment decisions for the investment trust’s management team.
9) How much does the investment trust deviate from its benchmark?
The investment trust has a high active share and, as such, is highly differentiated from its benchmark on a stock-specific and sector basis.
10) Does the investment trust use gearing and if so is it structural or opportunity led?
Since taking over the trust in early 2021, its current management team have not deployed gearing and, at the time of publication, are holding net cash. The board has indicated that it will allow the use of gearing in the context of improving market conditions.