Invest in the heart of America
The US small cap market is entrepreneurial, diverse, and under-researched, characteristics that have historically made it a rewarding market for investors. With acknowledged expertise in US equities, J.P. Morgan’s US Smaller Companies Investment Trust team believes US small caps with high quality characteristics are well-placed to deal with the current economic challenges.
Small is beautiful
The long-term economic success of the United States is founded upon the depth and breadth of its thriving corporate sector, with ambitious companies providing a constant source of renewal and evolution.
With the potential for strong growth ahead of them, smaller companies can outperform over the long term and play a key role in driving productive economic growth.1
Nevertheless, there are always periods in which even the most attractive investment opportunities struggle to make progress – that is the nature of equity market investing. After producing robust returns in 2020 and 2021, the performance of US small caps was more subdued in 2022 in the face of high inflation, rising interest rates and the prospect of recession.
In our view, there are sound reasons to believe smaller companies can bounce back strongly from here, supported by resilient profits that are more focused on the US domestic economy.
First, we think that if the US does experience a recession, it is likely to be mild, which should mean a quicker recovery.
Second, US consumer sentiment appears to be close to a trough, having last year hit the lowest level recorded in more than half a century. Troughs in US consumer sentiment have historically been a leading indicator for equity market returns: the average 12-month return for the S&P 500 is 25% following the eight troughs in sentiment we have seen since 1975. While there is no guarantee that this pattern will continue, we think it is a good signal for robust equity returns.
Lastly, equity markets themselves are discounting mechanisms that tend to move in advance of the real economy. This means the US stock market should already be pricing in the anticipated recession and its impact on corporate earnings. It is possible that the recession may be more or less severe than what is already priced in, but the stock market should be poised to recover well before economic conditions improve, setting up the potential for positive returns ahead.
Quality looks attractive
With more than six decades of combined investment experience, J.P. Morgan’s US Smaller Companies Investment Trust team has prospered through various types of market environment. A disciplined investment approach, with a focus on identifying high quality businesses, has been consistently deployed through these different conditions. The team is confident that this approach will continue to serve investors well, particularly given the attractive valuations that prevail for the stocks they favour.
The team is led by Don San Jose who has been lead fund manager on the JPMorgan US Smaller Companies Investment Trust (JUSC) for 15 years. The team looks for businesses with strong cash flow generation, high profit margins, an enduring competitive advantage, low capital intensity and management teams that are good stewards of capital, among other characteristics that are often associated with quality companies. Once the managers have determined that a business possesses these attractive features, they decide if it’s trading at an attractive enough price based on their assessment of its intrinsic value.
Disciplined execution of this quality-biased approach tends to result in a portfolio that is higher quality and less volatile than the broader market. The portfolio’s return on equity was 15% as of the end of the year – almost twice that of the Russell 2000 benchmark index – while its price-to-earnings ratio was lower than the benchmark and average 12-month forward earnings expectations were higher.*
Invest in the heart of America
Compared to the Russell 2000, JUSC is overweight the broad industrials sector, where the team has found many high-quality businesses that dominate the niche in which they operate, and are also benefiting from technological innovation.
These businesses represent the real United States – the engine of America’s long-term industrial success. They may lack the glamour and global profile of the large tech titans that dominate the US stock market index, but this is a positive. These smaller businesses have not received the same amount of attention from investors, and the valuation opportunity is therefore even more appealing.
The JUSC portfolio does have some exposure to the technology sector, where the team has recently been finding opportunities in more cyclical businesses such as semiconductors. Other high-growth parts of the market have also become more interesting, where company valuations have been pressured by higher interest rates and are now back at attractive levels.
But not all high-growth companies have become attractive. For example, many biotechnology companies in the Russell 2000 are young businesses that may not yet be generating revenues or turning a profit. Furthermore, they tend to be very volatile and unpredictable because their success is usually highly dependent on clearing regulatory hurdles and demonstrating the safety of their therapies as well as efficacy. These kinds of businesses are a poor fit for the JUSC portfolio.
Opportunities ahead for US small caps
The US stock market endured a challenging year in 2022, with high inflation and rising interest rates rapidly changing the way investors view the opportunity set. While further challenges likely await, the highly experienced JUSC investment team remains diligently focused on identifying businesses that represent the heart of corporate USA and offer outstanding long-term prospects.
JUSC’s quality bias should be beneficial in a potential recession, and also allow investors to participate in the subsequent recovery. US small caps have historically demonstrated an ability to outperform in situations like this and, if the recession proves to be mild, investors should not have too long to wait for the more positive market conditions to arrive.
The JPMorgan US Smaller Companies Investment Trust (JUSC) provides access to potentially fast growing smaller US stocks. The proven investment approach seeks out well-run companies with a record of attractive and sustainable profit.