Hiding in plain sight: the case for US smaller companies

What is a ‘smaller’ company in US terms?

Everything is bigger in the US, including its smaller companies.

The main smaller companies index is the Russell 2000 index, which aims to capture the smaller end of the Russell 3000 index. To UK investors’ eyes, these companies look far from small. According to Russell’s latest figures, the average market cap in the Russell 2000 is $4.1bn and the largest stock in the index has a market cap of $45.7bn¹.

What characterises US smaller companies?

Being at an earlier stage in their development, smaller companies tend to have higher growth and lower profitability, particularly in terms of free cashflow generation. They also tend to have higher levels of debt and less access to finance.

However, over recent years, balance sheets have improved as smaller companies have taken advantage of the previous lower interest rate environment to refinance towards longer-dated debt. Smaller companies are more likely to be loss-making than their larger counterparts – in 2023 around 40% had negative earnings².

US smaller companies also have a more domestic focus than the S&P 500: in aggregate the Russell 2000 derives about 80% of its revenues from the US³. They are therefore more closely tied to the fortunes of the US economy.

Because of the breadth of the smaller companies market, it is possible to target companies focused on a particular industry, service or region. Given the size and diversity of the US, it is inevitable that some local economies will be performing better than others.

An inefficient market produces opportunities

Fewer analysts cover US smaller companies than their larger peers, meaning there is greater opportunity to form a unique perspective on an industry or business. The market is also likely to be less efficient: we believe instances of mispricing are more common.

Average number of covering analysts and percentage of companies with no analyst coverage

Why invest in smaller companies now?

Trading at a discount to larger-cap stocks

As the market has increasingly focused on very large capitalised companies, smaller companies have significantly derated and are now trading at relative lows:

Small capitalisation stocks: forward-P/E ratio relative to large-cap stocks, 1976 to early March 2024

Valuations for profitable small-caps are particularly attractive. According to Russell, the Russell 2000 is trading on a PE of 16.5x, while the broader Russell 3000 is trading on a PE of 23.8x. This is despite there being little difference in 5-year earnings growth (14.4% for the Russell 2000 vs. 15.2% for the Russell 3000⁴).

Although January’s and February’s CPI inflation figures were higher than expected, we still see inflationary pressures moderating. Wage inflation, which had been fuelled by job switchers commanding higher salaries, has fallen as fewer people have changed jobs. ‘Shelter’ inflation (rent increases) had also been high due to lack of supply, but we expect that to come down as more apartments come on the market. We were encouraged to see the January personal consumption expenditures figure easing to 2.4%⁵, as this is the Federal Reserve’s target index.

Given the strength in economic data so far this year, expectations for cuts in interest rates have been moved further out, but the Federal Reserve is still expected to start cutting rates in the middle of this year. As smaller companies tend to have more debt and more of it is variable, they have underperformed as the Fed has been raising interest rates. History would suggest that this will start to reverse once they start to cut rates.

Rate cuts tend to favour smaller companies

Boom in domestic expenditure

While lower inflation and interest rates will benefit domestically-focused companies, there are also non-cyclical elements at work. Thanks to legislation passed over the last couple of years, there is significant spending planned to boost the US economy, mainly in transportation, clean energy and the domestic production of semiconductors, through the Inflation Reduction Act (IRA), the Infrastructure Investment and Jobs Act (IIJA) and the CHIPS and Science Act. Between the three acts, planned spending is around $2 trillion⁶.

With the presidential election looming later in the year, there is of course an element of uncertainty. But while these acts were introduced by the Biden administration, the majority of the infrastructure spending is focused on Republican states and so the policies are unlikely to be reversed should Trump win, although they may be tweaked.

Which opportunities would we highlight?

We think that there will be a strong recovery in a couple of sectors which in 2023 were still suffering under the distorting impact of Covid. In particular we would highlight healthcare and life sciences, where we see demand returning to normal. Another area that we think will recover strongly is demand for hard disk drives and NAND flash storage, for which we hold Western Digital and Seagate.

Elsewhere, we have a very positive view on the US housing sector. Broadly, there is a structural shortage in housing inventory in the US. Most mortgages are not portable and home owners are reluctant to move from a low mortgage rate to a high mortgage rate, meaning that recently they have tended to remain in their current houses and so secondary supply does not come on the market. This means that demand must be met with new build, favouring housebuilders and suppliers of building materials.

We are also relatively agnostic about the macro environment where we see two main scenarios taking place:

• First, that the US economy continues to be in rude health and rate cuts are not rushed, or
• Second, that there is weakness and rates are brought down in response

In both environments, we see our preference towards high-quality businesses rewarding us as 2024 progresses.