Invest in the heart of America

June 2024

This is marketing communication 

Investors are frequently told about the benefits of diversification, but sometimes market conditions can lead to returns becoming increasingly driven by a narrow band of stocks. This has clearly been the case in recent years, with large US technology companies dominating equity market performance, at times leaving practically everything else in their wake. Indeed, seven stocks – termed “The Magnificent Seven”1 by the media – delivered almost 70% of the entire total return from the S&P 500 Index in 20232. As a result of their outperformance, these seven stocks account for almost 30% of the entire index, making the US stock market more concentrated than it has been since at least the early 1970s3. This means less diversification for investors which, in theory, translates into more risk.

An opportunity to diversify

Although the action has clearly been elsewhere, there is an appealing alternative option for investors that would prefer a more diversified approach to the US stock market. It is often the case that, when markets become as concentrated as this, there will be another part of the market that is being overlooked by investors. Relative valuations suggest that, in current market conditions, it is US smaller companies that have been out of favour with investors.

This is evidenced in the graphic below, which shows that the collective market capitalisation of the entire Russell 2000 Index – a benchmark that has become known as a bellwether of the US economy by measuring the performance of around 2,000 of the smallest listed US companies – is currently smaller than that of the largest single stock in the US, Microsoft.

This potentially indicates two things. Firstly, there is a risk of over-valuation among the large US technology companies that have dominated market returns. Secondly, by contrast, US smaller companies may now be under-valued as a result of their lack of popularity.

Over long periods of time, there is an inverse relationship between starting valuations and subsequent long-term returns. Nothing is certain in investment, but this relationship should mean that if you invest when valuations are low, future long-term returns should be high and vice versa4. This bodes well for the outlook for US smaller companies but could represent a troubling omen for the popular technology giants.

The entire Russell 2000 index currently has a market cap less than that of Microsoft. Investors are frequently told about the benefits of diversification, but you currently 2000 US smaller companies for less than the price of one large one.5

Lessons from history

History also supports this notion. The chart below highlights that the previous occasions in which the US stock market has become over-concentrated in a narrow band of stocks (signified by the red dots on the green line) were the early 1970s in what was known as the “Nifty Fifty” market, and early 2000s during the infamous dotcom bubble. 

It is noteworthy that US smaller companies enjoyed a prolonged period of outperformance in the aftermath of these events, as indicated by the rising blue line from 1973 to 1984 and 2000 to 2011. 

History suggests, therefore, that this could be an appropriate time for investors to consider allocating away from the global-facing US technology giants, and towards US smaller companies.

The broad attractions of US smaller companies…

Why invest in the Magnificent Seven, when you can have the Magnificent 2000 instead? As well as offering greater diversification benefits, US smaller companies offer several other attractions. Smaller companies tend to outperform in the long run, by virtue of the longer runway of growth that lies ahead of them6.

Meanwhile, the US smaller company sector is renowned as one of the deepest market opportunities available anywhere in the world. Indeed, America’s historic economic success should, at least in part, be attributed to the diversity and entrepreneurialism of its thriving smaller company sector, which represents the real heart of corporate America.

…Coupled with the selective abilities of an experienced team

While broad exposure to US smaller companies may make sense for all the reasons outlined above, there is potentially an even greater opportunity for expert professional investors to capture.

It should be remembered that smaller companies carry a higher risk profile. Higher risk could offer the chance of higher returns over time, but it can also make individual smaller company share prices more volatile. This additional risk can be effectively mitigated through a sensible level of diversification and careful stock selection.

The team behind the JPMorgan US Smaller Companies Investment Trust (JUSC) consistently focuses on company quality as a defence against this volatility. More than a third of companies in the Russell 2000 Index are unprofitable, which tends to lead to even higher levels of volatility, particularly when equity markets suffer a setback7. The JUSC team’s disciplined focus on quality means many of these unprofitable smaller US companies are not considered for investment in the portfolio. Not that it’s a guarantee for the future but historically, this has allowed JUSC to deliver outperformance of the Russell 2000 Index alongside lower relative volatility and less downside risk.

The JUSC investment team is led by Don San Jose who has been managing the portfolio successfully for the last 16 years. Selecting largely from within the Russell 2000 Index, Don and his team have built a portfolio with some other very attractive financial characteristics, which tilt the odds of long-term success even further in favour of the Trust’s shareholders.

As well as offering higher quality (measured in the chart above by return on equity) than that of the index as a whole, the JUSC portfolio also has a lower valuation and offers faster potential growth.

Little wonder, therefore, that the team is confident that investing in the heart of America in a portfolio with these characteristics, should serve investors well in the years ahead.

Past performance is not a reliable indicator of current and future results.

Source: J.P. Morgan Asset Management/Morningstar as at May 2024. Net asset value performance (NAV) data has been calculated on a NAV to NAV basis, including ongoing charges and any applicable fees, with any income reinvested, in GBP.

NAV is the cum income NAV with debt at fair value, diluted for treasury and/or subscription shares if applicable, with any income reinvested. Share price performance figures are calculated on a mid market basis in GBP with income reinvested on the ex-dividend date. The performance of the company's portfolio, or NAV performance, is not the same as share price performance and shareholders may not realise returns which are the same as NAV performance.

Benchmark source: Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell© is a trademark of Russell Investment Group.

Comparison of the Company's performance is made with the benchmark. The benchmark is a recognised index of stocks which should not be taken as wholly representative of the Company's investment universe. The Company's investment strategy does not follow or track this index and therefore there may be a degree of divergence between its performance and that of the Company.

The Magnificent Seven stocks are Apple, Microsoft, Alphabet (Google), Amazon, Nvidia, Meta (Facebook) and Tesla.
2 Source: Forbes to 31 December 2023.
3 Source: J.P. Morgan Asset Management, Frank Russell Company, Furey Research, Factset to 29 February 2024, based on the concentration of the largest seven stocks in the S&P 500 Index as a % of total market cap.
Several academic studies have demonstrated the inverse relationship between starting valuation and subsequent long-term returns, including "The Cross-Section of Expected Stock Returns" by Fama & French (1992) and "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors" by Campbell & Shiller (1988). 
5 Source: Bloomberg as of 14 March 2024. The securities shown are for illustrative purposes only. Their inclusion should not be interpreted as a recommendation to buy or sell. 
Over the years, several academic studies have examined the long-term outperformance of smaller companies, including "Murphy's Law and Market Anomalies" by Dimson & Marsh (1999) and "Common Risk Factors in the Returns on Stocks and Bonds" by Fama & French (1993).
7 Source: Furey Research as of 29 February 2024. Past performance is not a reliable indicator of current and future results.