More than a hundred years of US financial market data consistently tells us that smaller companies outperform larger companies in the long run. But over the last decade, the opposite has been true, with large caps significantly outperforming. With US smaller companies expected to return to the ascendancy, we look at the reasons why it could now once again make sense to invest in the heart of America.
In the US, a thriving small cap sector is often cited as a key ingredient of the country’s long-term economic success. While smaller companies often come with higher associated risks, America’s small cap market is particularly entrepreneurial, diverse, and under-researched, —characteristics that have historically made it a rewarding market for those investors with long time horizons.
The Magnificent Seven effect
To understand the outlook for US smaller companies from here, it is helpful to explain the reasons why large caps have outperformed over the last 10 years. One major reason is that the US stock market has come to be dominated by a handful of increasingly large technology companies. Investors may remember the acronym “FAANG”, which stands for Facebook, Apple, Amazon, Netflix and Google. The term that has come to epitomise the phenomenon of large cap outperformance, particularly in the period leading up to and just after the Covid pandemic. In 2023, a similar trend with the Magnificent Seven, Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla was driving the majority of market returns. These seven businesses alone accounted for more than a quarter of the entire S&P 500 Index at the end of the third quarter 2023.
During this period, US small caps did well in absolute terms, with the Russell 2000 Index (a widely used benchmark for US smaller companies) delivering an annualized return of 5.6% in the ten years to 31 October 2023. But, as the chart below illustrates, they were somewhat in the shadow of the 11.2% annualized return in the S&P 500 Index as the effect of several mega cap stocks continued to unfold.
Small cap valuations are now supportive
While the dynamic of larger company outperformance continued so far in 2023, it might indicate a shift to a potentially better period for US smaller companies going forward. Having underperformed the S&P 500 Index in eight of the past 12 years, valuations in the Russell 2000 Index now appear attractive. In fact, they have only been cheaper 3% of the time over the last 33 years (based on J.P. Morgan Asset Management research). This valuation level is similar to prior periods, such as the tech bubble in the 1990s and the great financial crisis in 2008. Subsequent performance coming out of those periods was very favourable for US smaller companies for several years.
Smaller companies do well when markets turn
The promising backdrop for US small caps also includes an improving earnings picture in the face of elevated, but declining inflation coupled with higher interest rates. US smaller companies have often done well in such conditions.
Clearly, we still face some economic challenges, which should not be underestimated. The risk of a recession in the US in the next year may have receded somewhat in recent months as shelter, food and energy prices have declined, but higher interest rates continue to cause problems in some parts of the global economy.
Importantly, smaller companies tend to outperform as the US stock market emerges from a downturn. Once investors have some clarity about the health of the US economy, we could see the early stages of a rewarding small cap cycle.
The outlook for US smaller companies perhaps looks more encouraging now than it has for several years, particularly when viewed with the long-term horizons that ISA investors should apply. With valuations low and growth prospects tentatively improving, it may well be worth considering adding some exposure to US small caps within your ISA portfolio.
The JPMorgan US Smaller Companies Investment Trust plc offers an attractive way to access this opportunity. The trust is managed by a team of specialist investors with an average of 21 years’ industry experience between them, and a strong long-term track record in the US small cap market.
The managers look for well-managed, cash-generative businesses that enjoy an enduring competitive advantage and attractive growth prospects. These businesses represent the true spirit of the US economy, where underappreciated growth opportunities are abundant. That is why we believe an investment in the JPMorgan US Smaller Companies Investment Trust plc represents a rare opportunity to…
…invest in the heart of America.
The JPMorgan US Smaller Companies Investment Trust (JUSC) provides access to potentially fast growing smaller US stocks. The investment approach seeks out well-run companies with a record of attractive and sustainable profit.
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