US Smaller companies opportunities and 2 fund ideas

Investors shouldn’t necessarily ignore the US. Its stock market accounts for around 62% of the global market, dwarfing all of its nearest competitors. Over the last five years however, US small cap stocks have been left behind by their large-cap peers.

This article isn’t personal advice. If you're not sure if an investment is right for you, ask for financial advice. All investments fall as well as rise in value, so you could get back less than you invest. Past performance isn’t a guide to the future.

Mind the gap between small and large cap

US Smaller companies are trading at a significant discount to their large-cap peers. With higher inflation and interest rates hikes causing economic uncertainty, investors have preferred to invest in mega-cap companies with household names.

Small-cap companies tend to hold proportionately less cash and rely more on bank lending. Meaning, they’re typically more sensitive to interest rate changes than larger companies.

So, smaller companies earnings haven’t kept up, as higher interest rate payments take up a bigger share of their cashflows. This has led to a significant gap in performance where large-caps rallied, and small-cap performance has been more muted.

Now with US inflation generally trending in the right direction, with a slight bump in December, and the interest rate cycle likely having peaked, things are looking up. There’s a better chance that the US economy avoids recession or has a shallower recession instead of the deep one some investors were predicting.

After times of economic uncertainty like we’ve seen in 2022 and 2023, small-caps have historically recovered much quicker. History’s shown that small companies returned on average 8.6% in the 12-month period after an initial interest rate hike compared to just 6.2% for large companies. But during economic uncertainty, they tend to lag their larger cap peers and remember, past performance is not a guide to future returns.

Small-caps are trading at attractive valuations relative to their large-cap peers and their history. They are also expected to grow their earnings at a faster rate in 2024, and it could be seen as a potential opportunity.

Why invest in smaller companies?

Small companies can punch above their weight. They can also be some of the most exciting businesses around.

Some are pioneers of emerging industries and adapt quickly to new opportunities. Some could grow rapidly or blossom into the giants of tomorrow. But others will struggle or could even go bust because smaller companies are higher-risk investments than larger ones.

Smaller companies are usually under-researched which can create opportunities to uncover hidden gems. We think this is an area where active managers can show their stock-picking edge.

When investing in US smaller companies, we think it’s best to invest in higher-quality companies. We prefer managers who focus on quality because of the generally low-quality nature of this part of the US market.

This part of the market is becoming increasingly made up of loss-making businesses. Investing passively in a US smaller companies index means investors are investing in these loss-making businesses.

At the end of December, around 42% of companies in the Russell 2000 were loss making. This is especially concentrated in sectors like healthcare and technology, where over half of the companies made a loss.

2 fund ideas for US Smaller Companies

FTF Royce US Smaller Companies

FTF Royce US Smaller Companies aims to deliver long-term growth by investing in unloved US smaller companies, with potential to come back into favour or recover in future.

The fund’s run by Lauren Romeo with almost 30 years' industry experience investing in the US stock market. She has a strong support network of analysts and we like her disciplined approach which focuses on quality companies trading at attractive valuations.

Romeo focusses on companies that deliver a higher return on invested capital and return on equity than the benchmark. This has led to her investing just over 30% of the fund in Industrials and little to no exposure in the lower quality Utilities and Energy sectors.

Romeo runs a relatively concentrated fund which can increase risk.

Artemis US Smaller Companies

Artemis US Smaller Companies aims to deliver long-term growth by investing in smaller US companies.

Manager Cormac Weldon has over 20 years of experience investing in the US and is supported by a strong team of analysts. We like his disciplined approach to investing which leans towards growth orientated companies.

Like Romeo, Weldon also sees most quality small-cap companies in the industrials space where he also invests around 30% of the fund. But unlike Romeo he does have exposure to Utilities and Energy.

Weldon runs a relatively concentrated fund investing in 50-70 companies out of the thousands that make up the benchmark, which can increase risk.