Amid all the current turmoil the US economy, thanks in part to its relative energy independence, could fare better than its G7 counterparts.

Often when people look to invest in the US they focus on the mega-caps but it’s actually the domestic-oriented small caps which look particularly well placed.

A new era of deglobalisation, inflation and rising interest rates is leading to a domestic focus and could provide opportunities for this part of the market. Columbia Threadneedle Investments’ head of US equities, Nicolas Janvier notes small caps have outperformed in previous rate hiking cycles.

WHY THERE’S BEEN A SHIFT IN THE MARKET

Janvier points out that the 10 year-plus period of globalisation was tailor-made for the leviathans at the top of the S&P 500 riding the global technological wave – think Amazon (AMZN:NASDAQ), Alphabet (GOOGL:NASDAQ), Apple (AAPL:NASDAQ) and Microsoft (MSFT:NASDAQ).

However post-pandemic and now with the Russia/Ukraine conflict, ‘we have begun to see the emergence of a new environment: one of deglobalisation, rising prices, persistent and high inflation, rising interest rates and recession,’ says Janvier.

His observation is the global connections built up over the past few decades, particularly in food chains and energy supplies within Europe, are becoming problematic and a reliance on other countries, ‘particularly Russia for your gas, is not desirable.’

Yet the US, where the Federal Reserve is raising rates to combat inflation, stands a little bit apart from this situation. It has relative energy security due to its high domestic production levels, and it doesn’t import as much food as Europe.

‘It is, however, still experiencing rising rates and could well face recession, but it is showing resilience,’ says Janvier.

The US consumer also has a ‘huge store’ of spending power, notes Janvier, driven by the $5 trillion Covid-19 stimulus package which was designed to shield households and businesses from the pandemic shock.

IN A SWEET SPOT

‘Right now, US small caps are in quite a nice sweet spot for a couple of different reasons,’ says Janvier’s Columbia Threadneedle colleague and US fund manager Andrew Smith.

He notes they are much more inherently leveraged to the domestic economy. ‘If you look at the median breakdown of where revenues are sourced from, on average small caps are 90% to 100% domestic revenue, whereas the large caps are international companies.

‘In a situation where the US should hold up better than the rest of the world in a growth sense, then small caps should stand to do well,’ he adds.

Jon Brachle, one of the managers of investment trust JPMorgan US Smaller Companies (JUSC), points out the S&P 500 gets approximately 40% of its revenues from overseas compared to the Russell 2000’s 20%. ‘US small caps are much more of a domestic play, with around 80% of revenues coming from the domestic market.’

Despite some recent weakness in the dollar, the greenback remains strong against other currencies and dollar strength is a ‘huge headwind’ for large cap overseas earners according to Smith, because ‘when they translate their revenues back into dollars they lose a lot on the earnings. Being more domestic, small caps are more protected from the strong dollar effect, whereas international companies are feeling that a lot more and it is starting to show in earnings reports.’

Smith explains small caps tend to do well in times when borrowing costs are going up as rising rates ‘tend to be reflective of health in the underlying economy’. Inflation tends to go up when demand
is strong and ‘even though we are seeing a slowdown right now, we’ve had a very strong US economy. We’re thinking just a shallow recession and then a quick acceleration out of that next year and beyond.’

The well-regarded Cormac Weldon, manager of Artemis US Smaller Companies (BMMV576), finds it interesting that even in an environment where interest rates are rising and earnings growth has slowed significantly, capital expenditure is ‘up 20% this year’ and domestic companies have contributed significantly to and benefited from that trend.

‘We are entering a period of what we expect to be higher interest rates. Weaker companies only kept alive by the oxygen of low interest rates will start to suffer. We prefer good, strong businesses that can gain market share as more indebted, weaker competitors fail.’

WHAT ARE FUND MANAGERS BUYING?

Investors can access the asset class through dedicated funds such as Brown Advisory US Smaller Companies (BASC), the Chris Berrier-managed trust whose 12.3% discount to net asset value might tempt bargain hunters.

Berrier is bullish about Bentley Systems (BSY:NASDAQ), an industrial software company originally bought and sold previously on its initial public offering (IPO). Since then, Berrier has been waiting for the stock to decline toward his buy range and the recent sell-off in software moved it into the upper end of his purchase band. Berrier views this as ‘a great opportunity to get access to a high-quality company that we hope will reward our investors over the long term’.

Artemis US Smaller Companies’ Weldon says the strong dollar has been a headwind for many larger companies but less so for smaller businesses that are domestically focused. ‘In that sense investing selectively in small caps has been a way to play the tougher US economy without currency being a problem.’

He has recently been buying so-called ‘off-price retailer’ Burlington (BURL:NYSE), which buys excess inventory from other retailers cheaply and sells it on to price-sensitive customers.

Weldon says Burlington has ‘a great opportunity to increase profitability over the next number of years as freight costs plunge, supply chain difficulties diminish and there is more and more excess inventory’ and points out the strong greenback has enabled Burlington to purchase inventory overseas at a cheaper price too.

Weldon’s most recent purchase is housing industry building materials provider Builders FirstSource (BLDR:NYSE).

‘Rising interest rates have hammered the housing market and it is trading cheaply,’ he explains. ‘Over the next couple of years we believe there will be a housing recovery and in the meantime, this business is interesting because it provides computerised pre-cut timber framing that reduces the need for skilled joiners on site, which is helpful in a tight labour market.’

A fund which looks to blend growth and value is the Nicolas Janvier-managed CT American Smaller Companies Fund (B8358Z8). ‘We don’t want all our returns to be driven by just hugging a factor,’ explains Smith. ‘We’d rather just drive it from the bottom-up stock selection which is where we feel we have an edge.’ The focus is on ‘stocks where we are seeing improvement in their fundamental characteristics like improving market share, profits, return on invested capital, free cash flow that is underappreciated in the valuation right now.’

Top 10 holdings include WillScot Mobile Mini (WSC:NASDAQ), a portable modular storage company seeing underappreciated synergies following a merger. The Arizona-headquartered company also has ‘good leverage to construction, which is still having a good boost in the US’, and crucially in this inflationary environment, possesses pricing power.

Janvier and Smith also invest in cemeteries and funeral homes operator Carriage Services (CSV:NYSE), which Smith says has proved ‘really good at growing margins and cash flows through giving extra added value services to consumers’. Janvier and Smith are being selective when it comes to consumer-facing sectors, though Smith notes Texas-headquartered chicken wings seller Wingstop (WING:NASDAQ) has ‘done well coming out of the pandemic as things have reopened’.

COMPELLING VALUATIONS

Investment trust JPMorgan US Smaller Companies trades at a 10.7% discount to net asset value and aims to provide capital growth by investing in US smaller fry with sustainable competitive advantages that are well-run and trade at discounts to intrinsic value.

‘When we look at our universe of investable names, valuations are more compelling than they have been for some time,’ says manager Brachle.

He observes that the Russell 2000, a well-used proxy for small caps in the US, is currently trading at 11 times forward earnings, its lowest valuation level in more than three decades.

Brachle adds: ‘We are not trying to call a bottom, but are looking through to the other side, and trying to position the portfolio for the next three to five years.’

Holdings include service payroll processor Paycor (PYCR:NASDAQ), which has no non-US foreign exposure so generates 100% of its revenue in dollars. ‘It is neither positively nor negatively impacted by the strength of the dollar. The company is currently benefiting from a tight labour market in the US and a rising interest rate environment.’

In the third quarter, the trust bought shares in Freshpet (FRPT:NASDAQ), a provider of fresh, natural food choices to help improve the lives of dogs and cats which also owns and operates Freshpet Kitchens and Freshpet Fridges. Brachle likes Freshpet because it is ‘a market leader in fresh and natural pet food and we have historically liked the pet/animal health sector as we view pet food as resilient given its staple-like nature, and stickiness of the category’. This niche has ‘high barriers to entry (store refrigerator network, owned manufacturing assets),’ he explains.

‹ Previous2022-11-17Next ›