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 $3.3bn and the largest stock in the index has a market cap of $27.9bn.
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 US. They are therefore more closely tied to the fortunes of the US economy.
Trading at a discount to larger-cap stocks
As the market has increasingly focused on very large capitalisation companies, smaller companies have significantly derated. According to Russell, the Russell 2000 is trading on a PE of 15.5x, while the broader Russell 3000 is trading on a PE of 23.2x. This is despite there being little difference in five-year earnings growth (14 per cent for the Russell 2000 vs. 14.6 per cent for the Russell 3000).
Why invest in smaller companies now?
Although January’s CPI inflation figure was 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) has also been high due to lack of supply, but we expect that to come down as more apartments come on the market. This backdrop benefits smaller companies as when inflation falls confidence will increase and boost the fortunes of domestically focused companies.
In addition, we are now at the end of the interest rate cycle, with the Federal Reserve indicating at its December meeting that interest rates had peaked and signalling cuts in 2024. 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 (Chart 1).
Chart 1: Rate cuts tend to favour smaller companies
Source: Bloomberg, as at 2 January 2024, Russell 2000 vs. S&P500.
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 and energy through the Inflation Reduction Act (IRA) and the Infrastructure Investment and Jobs Act (IIJA). 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 acts are unlikely to be reversed should Trump win.
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.
The other industry we would expect to recover strongly is the memory-chip sector. This industry over- expanded in the wake of the pandemic and subsequently suffered a severe cyclical downturn in pricing and profitability. This oversupply situation is being corrected because the industry has stopped expanding production and demand for units has continued to rise because of investment in AI data centres. We would therefore expect to see significantly improved pricing.
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 builds, favouring housebuilders and suppliers of building materials.
