Investing in smaller companies has historically generated higher long-term returns than in larger companies. This “size premium” has been shown to exist in several important academic studies over the years, which have examined decades of financial market data1.
Smaller company outperformance doesn’t come in a straight line, however. There have been long periods in the past in which they have underperformed larger companies, including in the US in recent years. In this article, the second in a two part series, we look at the reasons why investment trusts could represent a highly suitable vehicle for investing in smaller companies and explore their prospects in the current environment, with specific reference to the opportunity that lies ahead for the JPMorgan US Smaller Companies Investment Trust plc.
Why an investment trust?
A UK-listed investment trust like the JPMorgan US Smaller Companies Investment Trust (JUSC) offers structural benefits that enhance the appeal of US small cap investing even further. One of the key advantages is its governance structure with an independent board overseeing all the trust’s activities and looking after shareholder interests. The board holds portfolio managers accountable and ensures they remain aligned and focused on long-term value creation.
Meanwhile, as closed-ended funds, investment trusts like JUSC benefit from a permanent capital base, meaning the portfolio managers are not forced to sell assets to meet regular redemptions during volatile times. This is of particular advantage when investing in smaller companies, which tend to be less liquid than their larger counterparts. It means the portfolio managers can remain fully invested and focused on generating sustainable, long-term returns from the opportunities they are finding in the US small cap market.
Another strength of the investment trust structure is the ability to use gearing (borrowing) to amplify returns. This allows the portfolio managers to invest additional capital in the opportunities they are finding at times when they are feeling particularly confident about the long-term outlook. Clearly, this can work in both directions, adding value in rising markets, but increasing downside risk in more challenging conditions. However, JUSC has a track record of adding value for shareholders through the use of a modest amount of gearing at appropriate times. JUSC currently has gearing of 3.3%2.
A word on risk
While US small caps offer attractive growth potential, they also come with higher risk. Smaller company share prices tend to be more volatile than for larger stocks, and values can fluctuate more widely in the short term, in response to changes in market sentiment and broader economic shifts.
This risk is partly mitigated by the JUSC team’s quality-focused and long-term investment approach. By investing in well-managed businesses with strong balance sheets and robust fundamentals, the team seeks to build a resilient portfolio that can weather short-term market volatility while capturing the longer-term growth potential that US smaller companies are capable of delivering.
Why now?
Although we know that smaller companies have historically outperformed in the long run, the chart below demonstrates that the “size premium” has not been in evidence in recent years. Following this period of underperformance, valuations among US smaller companies are now below historical averages. This discount relative to the wider market represents a potentially enticing entry point, especially for investors looking to gain exposure to growth opportunities in the domestic US economy.
Indeed, you can currently buy the entire Russell 2000 Index – a benchmark that measures the performance of around 2,000 of the smallest listed US companies – for less than the entire cost of Apple, nVidia or Microsoft3. Investors are frequently told about the benefits of diversification, but you can currently buy 2,000 US smaller companies for less than the price of one large one.
Meanwhile, in the aftermath of the US Presidential election, we have greater clarity on the likely policy environment for the next four years. Trump’s victory arguably signals a more business-friendly administration, with potential polices favouring deregulation and tax relief. Trump may also exert pressure on the US Federal Reserve to cut interest rates faster and further than is currently anticipated. Easier monetary policy is likely anyway, now that inflation appears under control again, and this could represent a powerful catalyst for a US smaller company renaissance. Smaller companies tend to be more sensitive to changes in borrowing costs and have historically done well at this point in the interest rate cycle, as investors have sought more risk for their portfolios.
Invest in the heart of America
The US small cap market represents an attractive way to access the entrepreneurial spirit and economic resilience that defines corporate America. US smaller companies sit at the very heart of America’s innovative economy, and with today’s favourable conditions, the long-term opportunity arguably looks as attractive as it ever has done.
It is important to be selective, however. Given the risks of investing in smaller companies, an active and disciplined investment approach such as the one adopted by the portfolio managers of JUSC, can often add additional value for investors, particularly over the long-term. Don San Jose and his team have considerable experience in this specialist area of investing and are very confident about the opportunity that lies ahead for investors looking to invest in the heart of America.
Read part 1 of “The case for US smaller companies”
