Artemis: Can US small-caps' run carry on?

Why invest in US small-caps? The US smaller companies market is larger and more liquid than many investors in the UK realise. By capitalisation, it is roughly the same size as the entire European equity market. And it is roughly twice the size of the UK.

US small-caps are also not small by European standards: the Russell 2000 index, the benchmark for the US smaller companies market, includes stocks with a market capitalisation of up to $10 billion.

These companies benefit directly from the size and dynamism of the US economy and the deep pool of venture capital available to fund innovative ideas.

If an idea becomes a product that has a competitive advantage, the company that invented it often comes to the US public market relatively quickly, at which point we can invest. That company then has the largest economy in the world as its home market. It can build scale and profitability and perhaps at a later date launch internationally, with the backing of a large profitable domestic market.

So far this year, US small-cap companies have outperformed large-caps. Is there more to come? Despite the re-rating, we still believe that smaller companies are attractive. Here we outline a number of the reasons why.

Secular trends supporting investment in smaller companies…

A number of trends in financial markets are affecting investors in smaller companies. These days, research activity by Wall Street firms is increasingly driven by the demands of banking and equity trading. To a large extent, this leads analysts to focus on researching very large companies. At the same time, the unbundling of execution from research is putting pressure on smaller research houses. As a consequence, research of small-cap companies is declining, which creates inefficiency in pricing and therefore opportunities for active investors.

Furthermore, growth in passive investing has driven money into the most liquid parts of the market and out of less liquid areas such as smaller companies. That too presents opportunities.

Making America Great Again: tax cuts, regulatory reforms and domestic exposure…

In addition to these secular trends, current US economic policies are favouring smaller companies. First, they are the biggest beneficiaries of Trump’s tax cuts as they were paying the headline tax rates with (unlike larger companies) no way to reduce them through international operations.

We think the tax cut/capital expenditure incentives have barely begun to be recognised. To some extent this is an expression of our confidence in the longevity of the economic cycle. We believe that it has years, rather than months, to run yet. If we are right, domestic companies have the wherewithal to reinvest to grow their businesses. If they choose not to do that, they can engage in M&A activity, which will also benefit smaller companies.

As one of Trump’s pledges was to cut red tape, small-caps stand to profit disproportionately from a more relaxed regulatory environment. And further to the point above about corporate activity, a less strict regulatory environment would encourage more M&A.

Potential trade wars have been one of the most prominent concerns in the US market this year. Due to the nature of their businesses, US smaller companies tend to have more domestic exposure and so will be less impacted by any tariffs or trading restrictions. The domestic exposure also makes them more geared to strong US GDP growth, which will in turn lead to small-caps producing higher revenue growth as they typically do so in an accelerating economy. Finally, their lack of overseas operations means that they are dollar earners and so are less affected by US dollar strength.

The Artemis US Smaller Companies Fund

Our fund is biased towards the mid-cap end of the smaller companies market. The average market capitalisation of our holdings is around $6.2 billion.

The fund is split between two main types of companies. First of all we have significant holdings in growth companies which we believe can continue to grow irrespective of the economic environment. A number of these companies are within technology and healthcare.

Axogen

One example is Axogen, a healthcare company involved in the treatment of nerve damage. Essentially, the company has come up with a way in which donated nerve tissue can be used to repair nerve damage. The current standard treatment for a patient who requires nerve damage repair is that the surgeon would recover nerve material from that patient (perhaps from their foot or back of their leg) and use that material in the process. Axogen’s solution means that the patient does not need to undergo the extra procedure in the operating theatre (which is expensive) and also reduces the risk of infection. Healthcare providers are focused on reducing costs which we believe will be beneficial to Axogen.

In addition, we believe economic growth will improve during the year – partly because of the recent tax cuts. As a consequence we also hold some companies that are more geared to the economic cycle and improving consumer trends.

Planet Fitness 

We recently bought Planet Fitness, a chain of gyms. The company operates as a franchise and runs gyms that it hopes will appeal to the average person who wants to exercise. So it does not offer the heaviest weights in its gyms, which might attract more dedicated gym-goers than its target customers. Because the gyms do not have additional classes or juice bars, they are able to offer subscriptions from $10 per month. The company continues to grow its franchise and we believe its scale will be a differentiating advantage in terms of advertising and maintaining gym equipment.

Offsetting these overweight positions are underweight positions in companies which tend to decline in valuation during periods of rising economic growth, namely “bond proxies”. Because bond yields tend to rise when economic growth gets better the valuation of these companies tends to decline. One example is real estate investment trusts where the fund is significantly underweight.

Fund performance

  Cormac Weldon - 28 September 2018