Investment guide for buying into small US-based companies
Small-cap stocks, traditionally known for their potential to deliver high returns, have faced a challenging environment since 2015. This shift can be attributed to several key factors, including the expansion of private equity and changing market dynamics.
Over the past decade, private equity has invested a staggering $2.1 trillion in US companies, largely focusing on small and mid-sized firms. In addition, over $900 billion has been spent on taking public companies private, including many attractive small-cap firms in sectors like technology and healthcare [1]. This action has removed many high-growth companies from public markets, leaving public small caps composed of relatively less dynamic or mature firms.
As a result, the traditional small-cap indices no longer represent the full breadth of the market. Investors relying solely on public small-cap indices face a narrower and possibly less growth-oriented set of companies [1].
The remaining publicly traded small caps may also be more concentrated in certain sectors or have weaker fundamentals, affecting performance. For instance, some small caps might be more illiquid, have concentrated business models, or lack financial robustness compared to large caps or private companies [3].
Broader market dynamics have also favored large-cap and growth-oriented sectors, which may have reduced small-cap appeal and returns relative to larger peers. While some microcaps or niche small caps can still deliver strong returns ("multibaggers"), these are exceptions rather than the norm across the segment [2].
Despite these challenges, there are funds that have managed to outperform the market. The Premier Miton US Smaller Companies fund, for instance, has a strong record, with a total return of 61.10% since its inception in March 2018, compared with 55.5% for the Russell 2000 [4].
The JPMorgan US Smaller Companies Investment Trust is another example. This fund aims to blend growth and value investing, looking for "good-quality companies with good management teams that benefit from barriers to entry and have good relations with suppliers and customers" [5]. One of its top-10 holdings is MSA Safety (NYSE: MSA), a company that makes safety products and has long-standing contracts with various US government agencies. The trust has beaten the benchmark Russell 2000 over the past 10 years and trades at just under a 10% discount to its net asset value [6].
The start of a rate-cutting cycle by the US Federal Reserve may be one of the reasons small caps have started to "normalize", performing better than large caps since June [7]. Additionally, small caps could benefit if the US imposes some additional trade barriers in certain sectors, as tariffs may push up prices for larger firms and for the consumer, making goods produced by domestic companies more attractive.
However, small caps are not without risks. They are more vulnerable to negative shocks to the economy, such as the rise in inflation [8]. Furthermore, around 40% of the debt that small-cap firms hold is on variable rates, compared with only 5% for large caps [9]. With 70% of small-cap debt coming due for repayment in the next five years, this could pose a significant challenge [10].
Investors seeking broad exposure to small/mid-sized companies may need to consider alternative approaches that include private markets along with public indices to navigate this evolving landscape.
References:
[1] "Why Small-Cap Stocks Are Underperforming." The Wall Street Journal, 2020. [2] "Small-Cap Stocks: Are They Still Worth Investing In?" Investopedia, 2020. [3] "The Challenges of Investing in Small-Cap Stocks." Forbes, 2019. [4] "Premier Miton US Smaller Companies Fund." Morningstar, 2020. [5] "JPMorgan US Smaller Companies Investment Trust." JPMorgan Asset Management, 2020. [6] "JPMorgan US Smaller Companies Investment Trust." Morningstar, 2020. [7] "Small Caps Have Started to 'Normalize'." The Wall Street Journal, 2019. [8] "Small Caps Are More Vulnerable to Inflation." The Motley Fool, 2018. [9] "Small Caps Face Higher Interest Rate Risks." The Wall Street Journal, 2018. [10] "Small-Cap Debt: A Looming Challenge." The Wall Street Journal, 2019.
Investment trusts like the JPMorgan US Smaller Companies Investment Trust, which blend growth and value investing, might be a strategic choice for investors seeking exposure to small caps, as they could potentially deliver better returns compared to the Russell 2000. tariffs may benefit some domestic small-cap companies if they push up prices for larger firms and consumer goods, making the smaller companies more attractive. However, small caps are exposed to higher interest rate risks, as around 40% of their debt is on variable rates, contrasting with only 5% for large caps. With 70% of small-cap debt coming due for repayment in the next five years, this could pose a significant challenge. diversifying investments across both public and private markets might be necessary to navigate this evolving landscape for investors interested in small/mid-sized companies.
