Are there opportunities in US small caps?

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Finding opportunities in US equities

Are there opportunities in US small caps?
(Pexels/Charles Parker)

“It has been an incredible decade or so for US equities,” says Columbia Threadneedle’s head of US equities, EMEA, Nicolas Janvier.

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.”  

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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.

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.