%20(1).jpg)
The Wild West of American Smallcaps
The past decade was that of the major American stock exchange companies. Not only did they outperform the stock markets in the rest of the world, but also outperformed their small counterparts, the small caps, at home. Nevertheless, those American small caps remain an interesting and underexplored hunting ground for investors, where there are many hidden gems.
In recent months, it seems as if only seven stock exchange companies - appropriately called the Magnificent Seven - still matter to investors. Those seven, not coincidentally all major American tech companies, drew all the attention and made investors forget that there is still a whole range of small and medium-sized American stock exchange companies, the small and mid-caps, where there are also many opportunities to be grabbed.
At the top of fund specialist Morningstar's list of the best-performing funds in that segment is the American Small & Mid Caps fund from Ghent asset manager Value Square. This achieved a return of 35 percent in the past year. In doing so, the relatively small Belgian asset manager beat his world-class colleagues, such as Schroders, Robeco and BlackRock. Trends spoke with Jens Verbrugge, the manager of the Value Square fund, about the opportunities and pitfalls in the US small and mid-caps, among others.
New revival
The Russell 2000 is the benchmark index for that segment of the US stock market. The major stock exchange companies, the largecaps, are represented in the Russell 1000 or S&P500, the best-known US index. The recent strong performance of the Russell 2000 against the large caps is a reversal in trend compared to the previous period (see Russell 2000 versus S&P500 graph). “Between 2017 and March 2024, the Russell 2000 achieved an annual rationale (price evolution plus dividends) of 7.5 percent. The S&P achieved almost double, mainly led by big tech, with 14.3 percent,” says Jens Verbrugge. In addition, ETFs that follow the S&P 500 saw record capital inflows last year.
But the roles have also been reversed. “Between 1999 and 2016, the small cap index achieved an annual return of 7.4 percent, compared to 4.5 percent for the S&P. Over the entire period, from 1999 to now, they both achieved almost the same annual return,” says Verbrugge.
In addition to the amazing stock market performance of the big tech companies over the past ten years, there are other reasons why the US small cap index has lagged behind in recent years. “For example, last year's US banking crisis affected many regional banks. They are well represented in the Russell 2000,” says Jens Verbrugge, “just like listed real estate companies or REITs (real estate investment trusts). They have had a very difficult time in the past period. First because of covid, which took a hit on both shopping centers and office real estate. After that, the wave of inflation caused interest rates to rise, further pressing the valuation of real estate”.
Since October last year, small stock market companies have been keeping up with the S&P500 star index. “Recession fears in the United States were tempered around that time. That played in the hands of the small caps, because they follow the economic cycle much more. In addition, the outlook for the first rate cut has given small-cap prices an extra boost, because they usually have higher debt ratios and interest rate cuts are good news for that,” said Andrew Smith, the manager of a fund in small American stock markets at asset manager Columbia Threadneedle.
Meanwhile, expectations about the Federal Reserve's interest rate cuts have been scaled back. At the end of last year, analysts expected six reductions this year. They've narrowed that down to three or even two. So the question is whether the recent revival of the little ones will be temporary.
Hidden gems
Apart from current market trends, the US small-cap market offers many advantages that make it a fertile hunting ground for investors, says Jens Verbrugge. “It is much more liquid than, for example, the European small cap market. In Europe, small companies often have very limited liquidity, so they are de facto uninvestable. If something is wrong, you are stuck in it.”
Transparency and clarity are another asset. Verbrugge: “Every listed company in the United States must submit standardized quarterly and annual reports. Everything is in English and in dollars. The political situation there is also easy to understand. All this means that the market is very easy to follow against, for example, Asia or even Europe. Try following an analyst call from a small Chinese stock exchange company.” However, this does not mean that the entire market is equally attractive or worth buying. “Smallcaps are just about the Wild West,” says Jens Verbrugge. “There are many high-quality companies, but just as many companies with questionable business plans. There are empty stock markets, cannabis stocks, biotech companies, and so on. The entire meme scene also takes place in that segment of the market. More than 40 percent of the companies in the Russell 2000 have made losses over the past twelve months.”
The fact that it is such a colorful bunch also distorts the valuation of the small cap index. “It currently averages at a price-to-profit ratio of 23,” Verbrugge calculates. You can call that relatively expensive, but the large group of loss-making companies skews that average. “Our fund is trading at an average price-to-earnings ratio of 11,” adds the Value Square analyst. So much more acceptable.
Passively playing the US small cap market with an ETF that follows the Russell 2000 is therefore not the most appropriate strategy. Compared to large-cap valuations, US small caps are currently at historically low levels (see Smallcaps historically rated lower than large caps graph).
Diversity is an asset
In addition to the clutter, there are also a lot of understudied strong companies or hidden gems among small American stock companies. “That makes it a rewarding hunting ground to do individual stock selection or stock picking,” says Jens Verbrugge. “First, it's a very wide universe, which increases the chances of finding high-quality companies that the market misprices.”
Much of that universe is also not on the radar of analysts and administrators. “Smallcaps are much less followed by analysts. What's not known is not loved, so they are often underrated. Coca-Cola Consolidated, for example, is the largest bottler in the United States. It generates a few billion dollars in sales per year and there is not a single analyst who follows it.” This underexposure can, however, lead to fluctuations. “The price movements cannot always be explained logically. Sometimes a company comes up with solid results and the price still gets a pledge.
One example is the IT hardware company ePlus. After the fourth quarter results, the price fell by 24 percent immediately after opening. By the end of the day, the decline was still 12 percent and a week and a half later, the share was even a few percent higher than before the publication of the figures,” says Jens Verbrugge. The fluctuations mean that investors have to do their homework. “In the face of such severe fluctuations, without anything fundamentally changing, the natural reflex is to start doubting. The stronger your analysis, the better you can respond to such price movements, because they also offer opportunities,” says Verbrugge.
Growth is another asset of small caps. “There are a lot of buy-and-build stories in that segment. The growth opportunities of small companies are greater than those of large caps,” says Jens Verbrugge. “And then there is the chance that companies will be taken over by private equity or by peers. This happens regularly, such as Masonite, a market leader in door production, which has been taken over by a competitor.”
For European investors, American small caps offer another specific advantage. “They're much more focused on the domestic U.S. economy, where they get most of their sales. This allows you to capitalize on the local economy, while large stock exchange companies are much more international and depend on the ups and downs of the global economy,” says Andrew Smith of Columbia Threadneedle. “For European investors, this diversification is an additional asset,” adds Jens Verbrugge.
American smallcaps...
Continue reading the article via Trends: https://trends.knack.be/geld/beleggen-2/het-wilde-westen-van-de-smallcaps-de-kansen-in-kleine-amerikaanse-beursbedrijven/
Disclaimer
- Source: Trends
- URL: https://trends.knack.be/geld/beleggen-2/het-wilde-westen-van-de-smallcaps-de-kansen-in-kleine-amerikaanse-beursbedrijven/
- Date: 11/04/2024
