Small Caps 

Are US small-caps being overlooked by investors?

This article is part of
One year of Trump: A guide to investing in the US

Are US small-caps being overlooked by investors?

UK investors generally have more exposure to US large-caps than to US mid- and small-caps in their investment portfolios.

This is not surprising as increasingly investors as the smaller end of the market cap spectrum is often considered a more niche area.

But it is being exacerbated by the fact investors are gaining exposure to US equities via passive funds and instruments.

For example, an S&P 500 tracker is skewed to large-caps and, in particular, to the technology giants such as Amazon and Apple, which account for a significant proportion of the index.

That means often investors are overlooking the return prospects of small and mid-caps in favour of the well-known technology companies.

Figures from the Investment Association back this up, with net retail sales of the North America sector hitting £302m in April 2017, while the North American Smaller Companies sector clocked up just £7m in August last year and in one month reportedly had absolutely no net retail sales at all.

But with the prospect of more interest rate hikes to come from the Federal Reserve and Donald Trump's much-talked about tax overhaul, which is likely to favour domestic companies, there could be a further boost for US small-caps this year.

Investors may be wise to diversify their US equity allocation and at the same time reduce their overreliance on one part of the market.

Small-cap outperformance

As Viktor Nossek, director of research at WisdomTree in Europe, notes: “Broad small- and mid-caps exposure will offer investors growth at a reasonable price, especially since it’s where the proposed tax reform will have the biggest positive impact to shareholder returns.

“More so than the sector, it’s the focus on size as a style strategy that allows investors to attain exposure to an equity segment that, while expensive, may now look better value when the tax reforms are legislated.”

Indeed, small-caps are looking expensive which may be deterring investors. But then so too is most of the US equity market.

“Small-caps are currently trading at a higher P/E [price to earnings ratio] than large and mid-caps, partly due to the risk-on environment, in which small-caps often outperform but also because a large share of the expensive biotech sector stretches the valuation,” explains Ritu Vohora, equity investment director at M&G Investments.

“But there are opportunities within small-caps for investors looking for quality stocks. Materials, industrials, consumer discretionary and consumer staples all offer [return on equity] ROE numbers between 21 per cent and 23 per cent.”

She adds that small-caps typically outperform during periods of interest rate rises because they raise most of their capital from equity, while large companies tend to raise capital through debt.