Invest in the heart of America
May 2024
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Investors in equities have faced a stark choice in recent years: allocate ever larger sums to a handful of very large US companies, mostly in the technology sector, or risk underperforming global benchmarks. But while the ‘Magnificent Seven’ stocks (Apple, Microsoft, Alphabet/ Google, Nvidia, Amazon, Meta/Facebook and Tesla) between them accounted for over 15% of the MSCI All Country World Index (ACWI) and more than a quarter of US equity market capitalisation at the end of 2023, they are far from the only game in town.
Don San Jose, manager of the JPMorgan US Smaller Companies Investment Trust (JUSC) has been investing in US equities for 27 years and has managed JUSC since 2008. He notes that going right back to the 1930s, there have been clear cycles in which US large-caps outperformed small-caps, and vice versa. And with larger companies having held the upper hand since 2012, signs are emerging that the pendulum may be about to swing the other way.
The US has the largest and most liquid stock market in the world. The biggest listed companies make up the S&P 500 index, home to stocks such as Microsoft (with a market capitalisation of nearly $3 trillion) and Apple ($2.5 trillion). With a total of roughly 6,000 companies listed on the New York and Nasdaq stock exchanges, around 5,500 of them are by definition ‘smaller’ companies, providing an enormous opportunity set for a small-cap fund manager.
Attractive valuations in US smaller companies
JUSC focuses mainly on the companies that make up the Russell 2000 index – broadly, the next-largest 2,000 stocks after the S&P 500. Often with a more domestic focus than the multinational behemoths at the top of the S&P, the Russell 2000 offers investors the chance to ‘invest in the heart of America’. The entire index in aggregate is smaller than Microsoft. Here, the median market capitalisation is about $1 billion and the weighted average is $4.8 billion. Within this pool of 2,000 stocks, San Jose and his team are looking for three key attributes: quality businesses, with quality management, trading at attractive valuations.
At present, attractive valuations are not hard to find. Smaller companies in the US have historically traded at a premium price-to-earnings (P/E) ratio compared with their larger brethren on account of their higher earnings growth prospects. Put simply, if a business is good, its profits should grow, but it is far easier to grow earnings from $10 million to $20 million than from $10 billion to $20 billion. Since the pandemic, the average Russell 2000 12-month forward P/E has been below the long-term average premium of 1.3 times, reaching parity with the S&P 500 P/E for the first time since 2001.
“Smaller companies also offer compelling value relative to their own history, not just versus large-caps,” says San Jose. “Right now, they are about as cheap as they have ever been.”
What the portfolio managers mean by ‘quality businesses’
However, valuation is arguably the least important of the three things JUSC looks for in an investment. “While we are never going to pay more than the average for similar companies, we would pay up a bit for a high-quality business,” the manager explains. “Even an A+ management team can only do so much with a B business.”
Happily, there is no shortage of quality businesses or managers in what is known as the most entrepreneurial market in the world. “What we are looking for is companies with strong competitive advantages, durable franchises, high barriers to entry, niche leaders – these are all good definitions of quality,” says San Jose, who currently holds 84 stocks in the approximately £300 million JUSC portfolio. The team meets with at least one company a day, and sometimes many more, both in the hunt for new ideas and to keep abreast of existing investments.
Current areas of focus include industrials, the consumer, financials and technology. “It is easier for us to find an edge in industrials (currently 27% of the portfolio versus 19% of the index), whether in higher-margin, more defensive businesses or in more cyclical areas, such as those benefiting from infrastructure spending under the Inflation Reduction Act,” the manager explains. “Materials is another overweight; like many consumer stocks, materials firms benefit from improved economic activity.”
2024 earnings growth for the Russell 2000 expected to be 15-20%
Given the more domestic focus of many smaller companies, the health of the US economy is an important factor. This is proved better than had been expected just a few months ago: while the market began the year pricing in six rate cuts from the US Federal Reserve in 2024, now the expectation is for two or three at most. “The economy remains strong, driven by consumers who are flush with cash and willing to spend it,” says San Jose. “GDP is robust, and the data tells us the demand is there. Meanwhile, costs are coming down: inflation is heading in the right direction, and has proved manageable for both consumers and corporates. Even labour pressures are easing, in terms of both wages and availability.”
Such a potentially benign backdrop should help to drive corporate earnings, which have been challenged in the past two years because of supply chain constraints and higher inflation. “In 2024, earnings growth for the Russell 2000 is expected to be 15-20%, which compares favourably not just to the last two years in small-cap, but also to the large-cap universe: the S&P 500 earnings growth forecast is 12-14%,” San Jose explains.
This pick-up in earnings growth, combined with historically low valuations, could be just what the small-cap sector needs in order to pick up the baton of outperformance, which it last held between 2000 and 2011. “We see a lot of parallels with the bursting of the technology-media-telecoms (TMT) bubble in 2000,” the manager says. “In 2000, the bubble was driven by large technology companies. Today we have the artificial intelligence (AI) frenzy. However, so far this year the Magnificent Seven have already become the fab four or five, and we have been seeing a market rotation towards more value sectors such as energy and financials, which make up a bigger part of the small-cap universe (around 28% of the Russell 2000 versus around 17% of the S&P 500).” This is leading him to feel optimistic about the prospects for US smaller companies. “As the market improves and sentiment recovers, we could see people return to the asset class, and that is why now is a particularly interesting time,” he concludes.
