Are there opportunities in US small caps?

A 10-year-plus period of globalisation in which the companies at the top of the S&P 500 found themselves in a “seemingly tailor-made situation” – very big, high-quality businesses, such as Amazon, Alphabet, Apple, Microsoft, riding a technological wave. 

“With the biggest growth not happening in the US and Europe but in China and India – yet still it was US tech giants that benefited from this.”  

A turn away from globalisation, a more domestic focus, could prove pretty compelling for US small-cap companies.Nicolas Janvier, Columbia Threadneedle

Now though, the winds of change are blowing against the giants – favour has instead fallen on smaller companies.

“US large-cap companies will remain phenomenal businesses; we believe Amazon will continue to grow, as will Microsoft and its cloud services,” says Janvier, “but a turn away from globalisation, a more domestic focus, could prove pretty compelling for US small-cap companies.”

Why small caps?

US small caps offer investors exposure to companies that derive most of their earnings from the US. If you look at foreign revenue exposure by market cap size, for example, small caps are much more domestically oriented businesses. 

Also, because they are earlier in their life cycles, small-cap companies can offer higher earnings growth rates over time than their large cap peers.

Amid a strong dollar (recent dollar surges and the euro and sterling’s slides brought parity between the dollar and euro for the first time in 20 years, and not far off for the pound), smaller US companies are more likely to benefit than large caps.

Small-cap stocks are trading at historically low valuations, fully reflecting investors’ concerns of a coming recession.Eric Papesh, T Rowe Price

He says this is because a strong dollar will have consequences for company earnings – US companies that source a substantial share of revenues from overseas will discover the currency strength will eat into profits when foreign currency revenues get translated back into US dollars. By and large, this is an issue for the large-cap companies. 

With small caps, as Janvier points out, “you can almost get the opposite effect; their revenue base remains good, with most of their growth being in the US, but their supply chains remain global. The strong dollar means that their purchasing power gets a little bit stronger.”

Small caps now?

According to Columbia Threadneedle research, historically smaller companies tend to lag large caps when interest rates fall but outperform in a rising rate environment, like now.

It found since 1962 – the furthest back the fund house can go for reliable data – in months when interest rates rose, the S&P 500 returned 6.1 per cent and smaller companies returned 14 per cent. Conversely, in the months when interest rates fell large caps returned 14.9 per cent and small caps delivered 10 per cent.

Janvier says: “One of the reasons why smaller companies outperform in periods of rising rates and more normal inflation is because that’s generally a sign that an economy is healthy. It is harder to say what that means when inflation is running at 8 per cent-plus. We shall see.”

The coming recession certainly muddies the waters for small caps. But Eric Papesh, portfolio specialist for US equities at T Rowe Price, says in the current environment they still look attractive.

If you’re building an active portfolio, you might want to think about getting quite far away from the index composition.Ben Seager-Scott, Evelyn Partners

He says: “Compared to large-cap competitors, small-cap stocks are trading at historically low valuations, fully reflecting investors’ concerns of a coming recession. But at the same time, earnings have held up reasonably well and are likely to improve once the economic outlook stabilises.”

Building a portfolio with small caps

That being the case, how can investors best use US small caps in a portfolio right now?

Diversification is still key, even with a focus on small caps, and in fact a greater focus away from the main indices is looking a better bet right now.

Ben Seager-Scott, head of multi-asset funds at Evelyn Partners, says: “If you’re building a US equity portfolio right now, I suggest you really need to be thinking about the composition.”

For the past few years, he notes, US equity has done very well, but has had a bit of a tailwind from its sectoral composition – that is, lots of technology, not very much energy. 

“So if you’re building an active portfolio, you might want to think about getting quite far away from the index composition and look for much greater sectoral and style diversification, as well as looking for great companies,” he adds.

Earnings estimates for small caps may still be too high.Alec Murray, Amundi US

Alec Murray, head of equity client portfolio managers at Amundi US, said US small caps are a good supplement to US large-cap exposure, with some caveats.

“Small caps have much more exposure to cyclical stocks, such as industrials, than large caps. This cyclical sensitivity means small caps typically underperform large caps entering into a recession, but often outperform coming out of a recession,” Murray notes.

The current valuation of small caps relative to large caps is low relative to historical averages, he points out, suggesting small caps are already discounting a recession, at least in part.  

“Earnings estimates for small caps may still be too high,” Murray adds, “so we believe a prudent approach is to have only a modest allocation to small caps and add to them on weakness if and when a recession materialises.”

david.thorpe@ft.com