Two small-cap funds with big potential

America’s S&P 500 index is widely held to be in a bubble, or at least very expensive. But when it comes to medium-sized and small companies, it’s a different story. The forward price/earnings (p/e) ratio of the S&P 400 MidCap index is just 16.9 and that of the S&P 600 SmallCap index a mere 15.8, both in line with their 20-year averages. Given the historic record of small-cap outperformance over large caps, this makes US small and mid-cap stocks compelling value.

Catching up with a rival

The better-performing of the two investment trusts specialising in this area has historically been the JPMorgan US Smaller Companies (LSE: JUSC) with a five-year investment return of 86% and £300m of net assets. But its rival, the Brown Advisory US Smaller Companies (LSE: BASC) with £190m of assets, has outperformed it over one year and is now close behind over five. BASC’s management was moved from Jupiter earlier this year and an improvement is already discernible. Chris Berrier, the new manager, took over on 1 April and quickly aligned the portfolio in line with the Brown Advisory US small-cap growth fund. This has led to a marked improvement in performance in absolute terms (5.5% in six months), relative to JUSC (1.4%) and compared with the Russell 2000 index (1.8%).

In the 15 years that Berrier has been lead manager of the $8bn US small cap fund, it has delivered a compound annual return of 11.6%, nearly 4% ahead of the Russell 2000 index. He is confident that returns in the low double-digits can be maintained through a strategy of investing in quality companies with durable, above-average growth, but avoiding early-stage companies with no earnings. There are no borrowings to enhance returns, but Berrier expects to introduce these opportunistically. The portfolio has 77 holdings, none worth more than 4% of the total, with significant tilts towards healthcare (26% of the portfolio) and information technology (25%) at the expense of financials and property (2% each). Companies with a market value of $1bn-$2.5bn “are in the sweet spot”, with Berrier looking to exit when they reach around $15bn. This resulted in the recent sale of Etsy, the handicrafts e-commerce company and a classic beneficiary of lockdown.

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It also resulted in “my biggest mistake – the premature sale of Salesforce.com”. Berrier is refreshingly open about mistakes. “We have become more aggressive at selling disappointing performers where the thesis hasn’t work as expected,” such as Vimeo, which offers software tools for content production. When the thesis does work, investments will be held for ten years or more, so annual portfolio turnover is not much over 30%.

Cashing in on child care

A classic example is Bright Horizons, which operates around 1,000 pre-school nurseries and child-care centres, including a growing number in the UK. Berrier believes that it is in a strong position to acquire single-facility operations from those less able to withstand disruption, cost inflation and staff shortages, or handle safety and security issues.

Workiva, another top-ten holding, offers software-as-a-service to help companies comply with the remorselessly rising burden of regulatory and reporting requirements. Market leader Workiva is locked into long-term growth.

Many of the larger US companies are household names, but few in the mid- and small-cap universe, but this is no reason to ignore a critical part of the world’s biggest stockmarket by far. Both BASC and JUSC should be much bigger trusts, but first they need to attract investors’ attention. With BASC’s shares trading at a 12% discount to net asset value compared with 5% for JUSC, it looks the better bargain. But both represent great long-term value.