Disclaimer
This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.
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.
Fresh perspectives
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%.
