The bears of the US stock market are pointing out that, but for the “MegaCap-8” which accounted for 26.4% of the S&P 500 at the end of May, the index would be down in the year to date. Excluding these stocks, the S&P 500 is down 1.4% and trades on a multiple of 16 times forward earnings but with them, it is up 9.5% and trades on a multiple of 18.3.
The valuation of the mid and small-cap indices is considerably lower, on forward multiples of 13.3 and 13.2, according to Ed Yardeni. For most of the last 20 years, though not since 2018, the valuations of these indices have been higher than for the S&P 500 but now they trade on a near-record discount of 28%. Yet though the earnings of these indices are expected to fall around 10% this year against a small increase for the S&P 500, double-digit growth is expected in 2024.
US small caps are cheap
This makes it a very good time to be looking at US small and mid-cap investment trusts. The £169m Brown Advisory US Smaller Companies Trust (BASC) trades at a 15% discount and the £292m JP Morgan US Smaller Companies Trust (JUSC) at a 10% discount. Both have returned around 20% in the last five years, 9% ahead of the Russell 2000 index excluding income.
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Jon Brackle, co-manager of JUSC, points out that small caps have underperformed for seven consecutive years, leaving the Russell 2000 index with a combined market value of less than Apple. “The argument for mean reversion is compelling,” he says, “but patience could continue to be required due to macro-economic and geo-political factors.”
A focus on stock picking
This year started well with the Russell 2000 rising 8% but it then gave all of that back. The small-cap stocks that have performed well are in the technology and biotech sectors, particularly companies without earnings. These account for around 40% of the Russell 2000 but much less at JUSC. As a result, JUSC’s year-to-date performance lags the Russell 2000 by 9% excluding income.
At BASC, Chris Berrier is also averse to companies without earnings but they still account for a “lower teens percentage of the portfolio.” His style is growth-orientated but “we care deeply about valuations” as does the team at JUSC. Both managers emphasise “quality,” stable businesses with visible long-term growth, low cyclicality, good margins and hence solid earnings and cash flow. They invest with a three to five year view.
With 80 holdings for BASC and 100 for JUSC out of a universe of 2000, both trusts are very differentiated from the Russell 2000 index (and they both share an aversion to the energy sector).
The stock selection criteria for both trusts are similar, but it is Berrier who emphasises “small-cap companies that have the potential to be much larger.” BASC has much higher exposure to healthcare, but less in industrials and financials.
He also has the humility to own up to his worst performers, though two of his bottom five in the year to date are companies that have “nothing wrong with them but don’t have the attributes for current market conditions.” The stock examples for both funds sound compelling.
On a higher discount and with better one-year performance, BASC, despite its smaller size, is the more compelling of the two right now. It also has the slightly lower annual management charge of 0.70% compared to JUSC’s 0.75% (the total ongoing charges figures were 0.97% and 0.95% respectively for 2022).
Still, both are excellent funds with great records of adding value over the medium to long term in an anomalously attractive area of global markets.
Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
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