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.
After enduring the most rapid rate hiking cycle of the past 40 years and a plethora of seemingly interminable macro-driven vacillations, it has been remarkable to see US stock valuations remain stubbornly high this year.
Whether the much-vaunted soft landing will take place remains to be seen but if it does, then it would call to mind that famous Von Bismark quote – that God has a special providence for fools, drunks, and the United States of America.
On 20/07/2023, the US MSCI Index was trading at a forward earnings multiple of 20.2. By comparison, the UK was trading at close to half of those levels and the MSCI Japan Index, the second-highest relative to the US, was still trading at a multiple of 14.4.
However, returns have been driven almost exclusively by tech stocks in 2023, fuelled by huge amounts of hype surrounding artificial intelligence. Data produced by S&P Dow Jones earlier this month found that over 75% of the returns delivered by the S&P 500 in first half of this year were attributable to just seven companies – Apple, Amazon, Alphabet, Microsoft, Nvidia, Tesla, and Netflix. So déjà vu all over again.
One take away from this could be that the US warrants higher valuations because companies in the Land of the Free continue to generate superior earnings growth – an argument that is made more compelling if you also believe we may be entering a reflationary trade.
In that case, it may make sense to simply target those companies delivering outperformance via a tech-focused trust. Allianz Technology Trust (ATT) is one such fund and, having suffered in 2022, the trust has bounced back over the last 12 months to deliver positive returns again for shareholders.
Another alternative is to invest via a US-focused trust, like JPMorgan American (JAM). JAM is arguably one of the more impressive trusts on the market today, for two reasons. One is that it has managed to deliver outperformance consistently – over 3, 5 and 10 year periods - investing in US large caps. Given the average US large cap has 21 analysts covering it, gaining an informational edge that can deliver outperformance in the sector is no mean feat.
The other is that the portfolio is style neutral, with there typically being relatively even weightings of value and growth stocks. Given how much performance has been driven by growth over the past decade, to deliver outperformance investing in this manner is commendable.
Of course, the other option may be that you think US valuations are too high. This would not be an illogical thing to believe. Looking at JP Morgan data, the S&P 500 was trading above its 25 year average, on six different valuation metrics, at the end of June. If you look at forward earnings multiples on a historical basis, the last time the index was trading at these levels – bar the bizarre meme stock boom during the pandemic – was at the tail end of the Dot Com bubble.
However, this is much less pronounced when you look at US small caps. Looking at Yardeni Research’s earnings data, the S&P 500 was trading at a forward earnings multiple of just under 20 on 25/07/2023. By comparison the S&P 400 MidCap and S&P 600 SmallCap indices were trading at equivalent multiples of 14.4 and 14.1 respectively.
Smaller companies in the US, as with most markets, have been hit hard by rate hikes and recessionary fears. As that implies, much of this has been sentiment driven and we see that many companies in underlying portfolios are holding up well, despite macroeconomic headwinds.
One trust that may be of interest for investors here is Brown Advisory US Smaller Companies (BASC). The trust’s board appointed Brown Advisory in April 2021, so it is still early days – although performance under manager Chris Berrier has been promising so far and Chris also has a long track record of outperformance in an open-ended fund.
Unlike the S&P 500, US small caps have been trading below their historical average. This is despite the fact that, again like the UK, smaller US firms have tended to deliver better long-term performance than their larger peers.
A bounce back may not be imminent, nor can further volatility be ruled out. But US small caps arguably offer more valuation conscious investors a more attractive entry point than large caps do today. BASC is also trading at a nearly 17% discount to NAV, also below its 5 year historical average, so there could be further benefit to investors here if sentiment changes and there is a tightening of the discount.
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