Are US small-caps being overlooked by investors?

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.

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.Viktor Nossek

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.

What is more likely is that investors simply do not know enough about US smaller companies to feel confident investing. 

Putting some money into a small and mid-cap fund is a way of getting exposure to this part of the market without having to do the stockpicking.

Dan Kemp, chief investment officer for Europe, Middle East and Africa at Morningstar, suggests: “Many people think about US equity exposures as either a diversifier or an opportunity to achieve better returns by targeting the fastest-growing sectors such as technology, or the most famous brands like Google and Apple.”

Investors would be wise to choose an appropriate allocation to small-cap stocks and stick to the allocation for the long term.Ryan Paterson

However, he reveals that by applying reasoned analysis to challenge this thesis, it can be found to be untrue.

“In fact, even when we isolate our analysis to the US market, we find that small-cap growth stocks are more attractive than the tech giants on a valuation-implied basis,” he says. 

“By digging deeper into this opportunity set, we find that small-cap tech companies are still well represented, making up approximately 23 per cent of the small-cap growth segment.”

Mr Kemp continues: “However, the more attractive opportunities come from other sectors, including small-cap healthcare, which makes up approximately 19 per cent of the small-cap growth segment and looks considerably better valued relative to fair value.”

Under-researched stocks

Part of the appeal of mid and small-cap stocks for portfolio managers is that there is not much coverage in terms of research, which means active managers can potentially add a lot of value.

Ryan Paterson, research analyst at Thesis Asset Management, considers himself a “big fan” of smaller US companies for this reason.

“They also have the ability to move faster and navigate more precisely, with fewer layers of management and other potential obstructions that exist in the typical bureaucratic organisation of large-cap companies,” he points out. 

“Investors would be wise to choose an appropriate allocation to small-cap stocks and stick to the allocation for the long term.”

Mark Sherlock, portfolio manager, US SMID (Small and Mid) Cap at Hermes Investment Management, has counted 51 analysts covering technology giant Apple and questions what he, as an investor, can add to that.

“Conversely, at the small- and mid-cap level there’s much more what we would call information inefficiency,” he notes.

In other words, there is much less sell-side coverage. 

“That’s important in building a differentiated portfolio and ultimately in increasing your chances of generating alpha which, of course, is what underlying investors want,” Mr Sherlock adds.

Passive tech exposure

The increasing use of passive products in portfolios is one of the reasons UK investors are disproportionately exposed to US large-cap stocks, whether they mean to be or not.

So, does this mean they are too reliant on the technology behemoths for returns?

Ms Vohora explains: “Most ETFs [exchange-traded funds] are market-cap weighted, meaning that capital invested in passives has generally benefitted large-caps more than small-caps, as already inflated large-caps have grabbed a larger portion of the capital.”

She believes that as interest rates rise and capital becomes more expensive, investors should turn away from the “crowded” passive space and move more money into active strategies, further boosting small-cap returns.

There is an argument for diversification, particularly in small- and mid-cap which can be a fertile hunting ground for an active investor.Mark Sherlock

David Coombs, lead manager of the Rathbone Multi-Asset Portfolio funds, agrees part of the uptick in technology share prices is down to the increasing share of passive cash in the market.

“This is exacerbating the momentum of stock prices, both up and down. But it is only on the margin; the main reason for the rise in technology companies is because of persistently strong earnings growth and the quality of their earnings at a time of relatively modest economic growth. 

“Still, scarce growth does increase the risk that investors pay too much for these companies,” he adds.

Investors have been predicting for years that the share prices of companies like Apple may come down and yet these firms continue to defy expectations.

Mr Sherlock says he is “wary of beating up” the Faang stocks.

“There are some very impressive businesses in there which have made huge inroads and seriously disrupted established business models. Retail, for example, is running scared of the ever more powerful Amazon,” he observes. “So I don’t think it’s as easy as just being able to dismiss them.”

What he does suggest is that incremental investors in any of the tech giants have to believe they will continue to be disruptors.

He reasons: “In which case, clearly it would be a good investment but I think… there is an argument for diversification, particularly in small- and mid-cap which can be a fertile hunting ground for an active investor.” 

eleanor.duncan@ft.com