Why US Smaller Companies Can Outperform

The US stock market is a notoriously difficult one for active fund managers to beat, but US smaller companies may be worth a closer look 

Annalisa Esposito 28 October, 2019 | 10:19AM
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The US stock market is a notoriously difficult one for active fund managers to try and beat. The breadth of different companies comprising the S&P 500 make it tough to outperform, particularly in recent years as the tech giants at the top of the index have soared.

But Morningstar Direct data suggests that investors looking to beat the market may be best turning their attention to smaller US companies. Over a five-year period, many US Smaller Companies funds have performed better than their benchmark. 

Small-cap stocks are a popular option for investors looking for fast growth. Smaller firms have the potential to expand their business - and profits - at a greater rate than their larger counterparts, but the key is to pick the right stocks.

Under-Researched Opportunities

The main reason active managers are better able to find opportunities among smaller companies, is because there are more small-cap firms than large-cap ones and yet fewer analysts are researching them.

Mark Sherlock, head of US Equities at Hermes Investment Management, calls this "information inefficiency". He says: "Around 50 analysts cover Apple, for example, whereas most of the companies in our index are covered by only three or four analysts, and some have no coverage at all. That means more opportunity to spot hidden gems that have gone unnoticed by other investors."

Nick Ford, manager of Miton US Smaller Companies fund, looks for companies at an earlier stage in their development, which are serving a fast-growing market. “From these you should expect earning growth and this ultimately drives the stocks price up,” he explains.

The fund, which only launched in 2018, is up 19.6% year to date. It invests in the fast-growing burger chain, Shake Shack (SHAK), which is targeting premium casual diners – compared to McDonald's, for example, cooking burgers to order and serving alcohol. 

Ford also like the healthcare sector. For example, investing in Teladoc (TDOC), a platform that connects doctors and patients through the internet. “This saves everybody’s time – doctors can see more patients and it reduces paperwork. Of course it’s not appropriate for all types of illness, but for many situations you can go online and access a doctor 24/7.”

US Small Cap Fund Performance

US small-cap funds

Among the top performing US Smaller Companies funds are Brown Advisory US Smaller Companies and JPMorgan US Small Cap Growth fund, which have produced annualised returns of 19.3% and 17.6% respectively over the past five years.

That compares with the MSCI USA Small Cap Index, which has delivered annualised returns of just 8.35% over the same period. The index is comprised of 1,791 smaller companies, and its largest sector weightings are financials and IT. 

Meanwhile, the Russell 2000 - another popular benchmark for US smaller companies - has delivered total annualised returns of 8.2% over five years. 

Small Cap Stars

The five-star rated Brown Advisory US Smaller Companies fund invests in innovative companies such as the childcare provider Bright Horizons Family Solutions, which helps parents find a nursery. It also holds Site One Landscape Supply, a company with over 500 stores across US offering irrigation and lighting products among others. 

The four-star rated JP Morgan US Small Cap Growth fund has almost 30% of its assets in technology companies and a further 20% in healthcare. Among its top holdings are Performance Food Group, which delivers foods to restaurants and vending machines across the US and Generac, a manufacturer of back-up power generation products.

At the bottom of the list are the Bronze-rated Legg Mason US Small Cap Opportunities and Neutral-rated Legg Mason US Smaller Companies funds. The former in particular has experienced strong volatility in recent years - while the fund returned 53.7% in 2016 and is up 17.3 year-to-date, weaker performance in other years has dragged on its overall returns over the past five years. 

Its fund manager, Bill Hench, says: "The small-cap space is more volatile than large-cap, it's just a different market. People jump in and out and we try to take advantage of that." The fund invests in more than 250 companies to spread the risk, and Hench likes companies that are looking to grow their profit margins. 

While investing in smaller companies can potentially reap rewards, this end of the market-cap spectrum is often more volatile than large-cap stocks. Smaller companies are often more domestically focused, meaning their fortunes are reliant on one economy, which can see them fall out of favour if there are concerns about the region.

In these instances, investors may instead turn to more-established rivals, with bigger balance sheets and great financial resources. For says: "Small companies often have less cash available and less experienced management teams, so they can make mistakes.”

As well as this, with fewer investors in these stocks, their share prices can rise and fall dramatically when a wave of investors all try to sell at once. Of course, this effect can work in reverse too: "When investors are optimistic there are not enough sellers for the buyers, the price can go up quite quickly," points out Ford. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Annalisa Esposito  is a data journalist for Morningstar.co.uk