Rob Forker, portfolio manager at Polen Capital, said the sector represented an “attractive opportunity” from both a structural standpoint and tactical allocation, given the current market environment.
He said the “persistent inefficiency of the asset class” from liquidity constraints and minimal analyst coverage represented a strong structural opportunity for active managers.
This is a good environment for US small-caps, he noted, because they appear inexpensive compared to both large caps and their own history.
When comparing small-cap and large-cap indices, he said that “one would have to go back to 2001 to see a comparable valuation spread to what we are seeing today on a forward one-year price-earning basis”.
Forker also argued that US small-caps had an advantage to those based outside the US, due to their greater exposure to “higher growth segments like biotech and software, while those outside the US borders have more exposure to cyclicals and consumer staples”.
“In a world of low- to mid-single digit GDP growth, we believe US small-caps are well-positioned to deliver above average returns for patient investors in the coming years,” he concluded.
‘A potential win-win’
Nick Ford, manager of the Premier Miton US Smaller Companies fund, echoed Forker’s sentiment, describing the outlook for US small-caps as “encouraging”, adding they present a “potential win-win outcome for investors in the current environment”.
Ford argued that the US is best placed to withstand the macroeconomic environment, as it is a net exporter of energy and will suffer less from interest rate increases due to the prevalence of long-term fixed rate mortgages in the country.
He also noted that US consumers “built up an enormous cash cushion during the pandemic, which should help support consumer spending in the coming years”.
However, Ford said that not all companies were well-placed to benefit from this. He pointed to large cap companies like tech stocks, which are experiencing slowing growth from pandemic legacies and overseas exposure.
“This is compounded by having to sell in depreciating local currencies, so lower profits are worth even less when repatriated home,” he added.
Meanwhile, small-cap businesses are set to benefit from the US’ “fortunate position”. Ford cited Driven Brands as an example, an automobile services company in North America.
He explained the diversification of the firm, through offering paint, collision, repair, maintenance and car wash services, as well as being asset light, made it very profitable and well-positioned to continue consolidating the sector.
Furthermore, Ford said that in the event of a recession, small-caps also have the advantage of having historically provided “excellent returns once the trough of the downturn has been reached”.
Rob Morgan, chief investment analyst at Charles Stanley, singled out Brown Advisory US Smaller Companies fund as a top pick in the sector.
Morgan described Brown as “experienced and well-resourced US small-cap investors” that “have the people and process in place to continue adding value”.
With a weighted average market cap of double that of the Russell 2000 Growth index, Morgan described the fund as “more of a ‘small- and mid-cap’ proposition” with a bottom-up investment process that has been “successful in picking winners” .
Morgan added the long-term returns have been strong, made more impressive with the fund’s volatility lower than the benchmark. The fund tends to lean towards healthcare, industrials and investment trusts.
He described the fund’s style as “quality growth”, which avoids the many unprofitable speculative growth companies in the benchmark, meaning it “tends to capture less market upside, but in more stressed market conditions it typically adds value”.
Morgan added: “The fund’s relative performance is at risk of a rally in the smaller end of the universe, or a resurgence in small-cap value as a style, such as that seen in the first half of 2021.
“In periods of bond yields picking up, such as early 2022, the fund will tend to struggle, because the cashflows of its companies are generally long dated in nature.”
Rosanna Burcheri and Ashish Bhardwaj, portfolio managers of Fidelity American Special Situations fund, said they tend to focus on “identifying investment opportunities in mispriced companies, rather than taking a sector view”.
They said that in the current market environment, the most interesting stocks have “credible structural growth tailwinds and wide economic moats around their business models but are trading below our intrinsic value estimates”. This comes from either cyclical concerns or firms not well understood by the market, the managers added.
Burcheri and Bhardwaj gave the example of firms that will benefit from the trend of electrification and decarbonisation initiatives, such as Carlisle, which are misunderstood by the market.
Carlisle manufactures and sells building material, which the managers said was well placed to benefit from a drive to make buildings more energy efficient.
“There is a structural tailwind behind this theme, catalysed by the fact that buildings from the past 10-20 years make up almost 25% of the current infrastructure, and a large proportion of the US housing stock is now likely the oldest on record at 44 years,” they said.
“Lots of Carlisle products play a key role in reducing carbon emissions (air/vapour barriers, walls and roofing insulation) and in yielding savings on heating and cooling, which in today’s elevated energy costs environment is front of mind for consumers.”
Meanwhile, the managers said they were avoiding overvalued firms, which is typically due to “their defensiveness or their high growth profile”.
“Right now, there are many high growth stocks, where the growth drivers are peaking and maturing but the stocks are priced as if their businesses are still in the early phases of growth. We prefer to avoid these kinds of investments which are most often found in the technology sector,” they added.