Ratings

22 Apr 2024

  Artemis

Artemis: Hiding in plain sight: the case for US smaller companies

While the giant US tech stocks have dominated returns over recent years, the shares of smaller US companies have languished and are now trading at a discount to larger companies. We believe this represents a very attractive entry point to one of the world’s most vibrant economies.

FOR PROFESSIONAL INVESTORS AND/OR QUALIFIED INVESTORS AND/OR FINANCIAL INTERMEDIARIES ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS. CAPITAL AT RISK. All financial investments involve taking risk and the value of your investment may go down as well as up. This means your investment is not guaranteed and you may not get back as much as you put in. Any income from the investment is also likely to vary and cannot be guaranteed.

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 $4.1bn and the largest stock in the index has a market cap of $45.7bn1.

What characterises US smaller companies?

Being at an earlier stage in their development, smaller companies tend to have higher growth and lower profitability, particularly in terms of free cashflow generation. They also tend to have higher levels of debt and less access to finance.

However, over recent years, balance sheets have improved as smaller companies have taken advantage of the previous lower interest rate environment to refinance towards longer-dated debt. Smaller companies are more likely to be loss-making than their larger counterparts – in 2023 around 40% had negative earnings2.

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 US3. They are therefore more closely tied to the fortunes of the US economy.

Because of the breadth of the smaller companies market, it is possible to target companies focused on a particular industry, service or region. Given the size and diversity of the US, it is inevitable that some local economies will be performing better than others.

An inefficient market produces opportunities

Fewer analysts cover US smaller companies than their larger peers, meaning there is greater opportunity to form a unique perspective on an industry or business. The market is also likely to be less efficient: we believe instances of mispricing are more common.

Average number of covering analysts and percentage of companies with no analyst coverage

Source: Furey Research Partners, FactSet, as at June 2023. Indices used include Large-caps S&P 500, Mid-Caps Russell Midcap index, Small Caps Russell 2000 index, Micro Caps – Russell Micro index

Why invest in smaller companies now?

Trading at a discount to larger-cap stocks

As the market has increasingly focused on very large capitalised companies, smaller companies have significantly derated and are now trading at relative lows:

Small capitalisation stocks: forward-P/E ratio relative to large-cap stocks, 1976 to early March 2024

Source: Empirical Research Partners analysis. Capitalisation-weighted data

Valuations for profitable small-caps are particularly attractive. According to Russell, the Russell 2000 is trading on a PE of 16.5x, while the broader Russell 3000 is trading on a PE of 23.8x. This is despite there being little difference in 5-year earnings growth (14.4% for the Russell 2000 vs. 15.2% for the Russell 30004).

Although January’s and February’s CPI inflation figures were 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) had also been high due to lack of supply, but we expect that to come down as more apartments come on the market. We were encouraged to see the January personal consumption expenditures figure easing to 2.4%5, as this is the Federal Reserve’s target index.

Given the strength in economic data so far this year, expectations for cuts in interest rates have been moved further out, but the Federal Reserve is still expected to start cutting rates in the middle of this year. 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.

Rate cuts tend to favour smaller companies

Source Bloomberg as at 2 January 2024. Russell 2000 vs. S&P500

Boom in domestic expenditure

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, clean energy and the domestic production of semiconductors, through the Inflation Reduction Act (IRA), the Infrastructure Investment and Jobs Act (IIJA) and the CHIPS and Science Act. Between the three acts, planned spending is around $2 trillion6.

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 policies are unlikely to be reversed should Trump win, although they may be tweaked.

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. Another area that we think will recover strongly is demand for hard disk drives and NAND flash storage, for which we hold Western Digital and Seagate.

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 build, favouring housebuilders and suppliers of building materials.

We are also relatively agnostic about the macro environment where we see two main scenarios taking place:

  • First, that the US economy continues to be in rude health and rate cuts are not rushed, or
  • Second, that there is weakness and rates are brought down in response

In both environments, we see our preference towards high-quality businesses rewarding us as 2024 progresses.

1Source for all figures Russell 2000 factsheet. As at 28 February 2024.
2Source: Morningstar Why the S&P 500 is destined to keep crushing the Russell 2000 | Morningstar
3How American is your US equity portfolio? | LSEG
4Source for all figures Russell 2000 factsheet 28 February 2024. PE ex negative earnings.
5Services drive US prices higher in January; inflation gradually cooling | Reuters
6House passes Biden's $2 trillion Build Back Better package : NPR

FOR PROFESSIONAL INVESTORS AND/OR QUALIFIED INVESTORS AND/OR FINANCIAL INTERMEDIARIES ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS.

Capital at risk. All financial investments involve taking risk and the value of your investment may go down as well as up. This means your investment is not guaranteed and you may not get back as much as you put in. Any income from the investment is also likely to vary and cannot be guaranteed.

This is a marketing communication. Before making any final investment decisions, and to understand the investment risks involved, refer to the fund prospectus (or in the case of investment trusts, Investor Disclosure Document and Articles of Association), available in English, and KIID/KID, available in English and in your local language depending on local country registration, available in the literature library.

Risks specific to Artemis Funds (Lux) – US Smaller Companies

  • Market volatility risk: The value of the fund and any income from it can fall or rise because of movements in stockmarkets, currencies and interest rates, each of which can move irrationally and be affected unpredictably by diverse factors, including political and economic events.
  • Currency risk: The fund’s assets may be priced in currencies other than the fund base currency. Changes in currency exchange rates can therefore affect the fund's value.
  • Concentration risk: The fund may have investments concentrated in a limited number of holdings. This can be more risky than holding a wider range of investments.
  • Smaller companies risk: Investing in small and medium-sized companies can involve more risk than investing in larger, more established companies. Shares in smaller companies may not be as easy to sell, which can cause difficulty in valuing those shares.
  • ESG risk: The fund may select, sell or exclude investments based on ESG criteria; this may lead to the fund underperforming the broader market or other funds that do not apply ESG criteria. If sold based on ESG criteria rather than solely on financial considerations, the price obtained might be lower than that which could have been obtained had the sale not been required.

Risks specific to the Artemis US Smaller Companies Fund

  • Market volatility risk: The value of the fund and any income from it can fall or rise because of movements in stockmarkets, currencies and interest rates, each of which can move irrationally and be affected unpredictably by diverse factors, including political and economic events.
  • Currency risk: The fund’s assets may be priced in currencies other than the fund base currency. Changes in currency exchange rates can therefore affect the fund's value.
  • Concentration risk: The fund may have investments concentrated in a limited number of holdings. This can be more risky than holding a wider range of investments.
  • Smaller companies risk: Investing in small and medium-sized companies can involve more risk than investing in larger, more established companies. Shares in smaller companies may not be as easy to sell, which can cause difficulty in valuing those shares.

Investment in a fund concerns the acquisition of units/shares in the fund and not in the underlying assets of the fund.

Reference to specific shares or companies should not be taken as advice or a recommendation to invest in them.

For information on sustainability-related aspects of a fund, visit the relevant fund page on this website.

For information about Artemis’ fund structures and registration status, visit artemisfunds.com/fund-structures

Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness.

Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice.

Third parties (including FTSE and Morningstar) whose data may be included in this document do not accept any liability for errors or omissions. For information, visit artemisfunds.com/third-party-data.

Important information
The intention of Artemis’ ‘investment insights’ articles is to present objective news, information, data and guidance on finance topics drawn from a diverse collection of sources. Content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security or investment by Artemis or any third-party. Potential investors should consider the need for independent financial advice. Any research or analysis has been procured by Artemis for its own use and may be acted on in that connection. The contents of articles are based on sources of information believed to be reliable; however, save to the extent required by applicable law or regulations, no guarantee, warranty or representation is given as to its accuracy or completeness. Any forward-looking statements are based on Artemis’ current opinions, expectations and projections. Articles are provided to you only incidentally, and any opinions expressed are subject to change without notice. The source for all data is Artemis, unless stated otherwise. The value of an investment, and any income from it, can fall as well as rise as a result of market and currency fluctuations and you may not get back the amount originally invested.


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