US Smaller Companies to Outperform

LF Miton US fund manager Nick Ford says innovative young companies, such as those involved in artificial intelligence, should do well in a thriving economy

External Writer 30 April, 2018 | 12:50PM
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This article is part of Morningstar's "Perspectives" series, written by third-party contributors.

Artificial Intelligence

Trade war worries, faltering market leadership from high-profile tech stocks like Facebook and a reassessment of the benefits of tax reform have resulted in heightened market volatility and increased concerns that the economy might be headed for a downturn.  We think the risks are overstated and we continue to be extremely optimistic on the prospects of continued growth for the world’s largest economy.

Our positive view is underpinned by several factors. First, measures of CEO confidence, small business optimism and consumer sentiment are near record highs. Investors seem to have lost sight of the tax reform tailwinds which have only just begun to influence economic activity. This year consumer and business spending should begin to increase and at this point, we think many US corporations have probably been unduly conservative in their earnings guidance following the passage of the reforms.

Second, we are encouraged by the fact that smaller companies as measured by the Russell 2000 Index have begun to outperform large firms. This is unusual at this point in the economic cycle and suggests that growth could persist for a number of years from here. Smaller companies usually underperform as a recession draws near. Finally, it is extremely pleasing to see that interest in recent IPOs has picked up. An index which tracks the performance of companies which have recently listed in the US is now leading the market. This is a very fertile area for fast growing and innovative young companies as investors look for the “FANGs” of the future.

Elsewhere, a key barometer of economic health – the housing sector – looks to be in very good shape. Household net worth is currently at record highs and the amount spent by consumers to service their debt, as a percentage of disposable income, near record lows. It is hard to see how homebuilders and related industries, such as providers of home furnishings, cannot continue to prosper in this environment. We recently met with the management teams of a number of US corporations across a wide range of industries and they appeared broadly optimistic and upbeat about the prospects for their businesses. The main feedback we received was that, if anything, economic growth appears to be accelerating.

Can a Trade War be Avoided?

Sabre rattling ahead of a possible trade war with China has certainly alarmed many economists but the potential for a favourable outcome has been given less attention. President Trump is close to agreeing a deal with South Korea whereby the Koreans will be exempted from steel and aluminium tariffs in return for greater access for US carmakers to the South Korean market.

The deal should be considered a blueprint for what could be achieved if all sides co-operate. We think there is a good chance that current tensions simmer down – China’s President Xi Jinping has already contemplated allowing foreign control of Chinese financial services companies and sourcing a higher percentage of semiconductors from the US as a way of diffusing the conflict.

If we are wrong in our assumptions about the outlook for growth there should still be plenty of opportunities for investors to make money in US stocks given that the entrepreneurial spirit in America remains alive and well. In particular, there are numerous innovative young companies with disruptive business models space that should be able to grow by gaining market from established competitors as they roll out superior products and services.

Examples within the healthcare sector include Nuance (NUAN) and Vocera Communications (VCRA) which are both using speech recognition and Artificial Intelligence to slash the bureaucracy associated with creating and retrieving patient records. Elsewhere, fast-growing Carvana (CVNA) has built an online platform for buying used cars. Prospective customers can inspect vehicles using the company’s 3D 360 degrees technology and save money by avoiding the commission that salespeople receive at traditional used car dealerships. The company’s consistently strong sales growth should continue irrespective of economic conditions.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Carvana Co Class A117.50 USD-0.36

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