Discover a new world of shares with this US trust

You might be familiar with the theory that small listed companies should outperform large ones over the long term because they have more room to grow. Over the past few years, this has not materialised at all. The US numbers are stark: in the decade to 19 July, the S&P 500 returned 317 per cent in sterling terms. The small-cap focused Russell 2000 returned only 175 per cent.

 As the chart below shows, the gap has grown larger since the 2022 bear market, although small caps did rally earlier this month. This was on the back of better inflation data and Donald Trump’s improved chances of winning a second term as US president. 

If you ask investment managers these days, they usually hold one of two opposing views: either they believe the US tech titans will continue to dominate, partly because they are prime beneficiaries of the artificial intelligence revolution, or they insist that markets will have to broaden out at some point, and the performance of lesser-known players will start to catch up with the disproportionate returns of the Magnificent Seven (or Six, given Tesla's (US:TSLA) recent difficulties).

Where a manager sits usually depends on his or her own investment mandate. But the wisdom of relying on a handful of US wonder stocks is certainly coming under scrutiny. 

If you share the view that markets look too narrow, US small caps are an interesting place to hunt for growth. “It's hard to know the exact trigger, but our view is that this level of concentration will end,” BASC manager Christopher Berrier recently argued at a Kepler Trust Intelligence event.

“When it does, there’s a historical precedent that small caps generally outperform… It’s a part of the market that’s ignored, versus a part of the market that’s overwhelmed. And so capital flows really only have one way to go.”

The timing of this shift is difficult to call. Small caps tend to do well when inflation and interest rates fall, so rate cuts in the US could catalyse a rally. The Fed is currently expected to make at least one cut before the end of the year, so some good news could be forthcoming before 2025. But if inflation proves sticky and interest rates stay higher for longer, investors might be forced to bide their time.

Managers at BASC look for quality stocks with strong fundamentals, in a market where "many companies are relatively immature, whether financially or operationally or in terms of management or market position" and tend to be highly geared to growth. Berrier says that while not all US small caps are cheap on an absolute basis, valuations in this quality universe do look attractive versus large caps. 

All these factors are making the managers cautiously optimistic about the trust's prospects, and have prompted them to consider making the portfolio more concentrated and employing some gearing.

“While we haven’t taken that on in earnest yet, given the changing conditions in the equity market and the fact that valuations are better, it is something that we would consider,” says Berrier, arguing the trust is attempting to place itself in the best possible position for the expected rebound. 

On the hunt for quality

With an investable universe of 2,000 companies which typically attract far less analyst coverage than large caps, US small caps offers plenty of opportunities for active managers, but identifying the winners is a big task. 

Despite the name, US smaller companies are typically bigger than their UK equivalents. As of September 2023, the average market cap for companies in the Russell 2000 was $2.9bn (£2.3bn), only slightly smaller than FTSE 100 group Burberry (BRBY). BASC tends to focus on the larger end of the spectrum and does not take positions that are larger than 5 per cent of the portfolio in order to manage downside risk. 

It also wants businesses that offer durable growth, a scalable ‘go-to-market’ strategy, sound governance, a higher-than-average return on capital, and lower-than-average debt. Sectors such as financials and real estate, which are particularly sensitive to interest rates, are avoided. 

As a result of this stockpicking process, the trust centres around the healthcare, industrials and consumer discretionary sectors. The industrial sector in particular could benefit from the 'reshoring' trend, with companies incentivised to transfer manufacturing back into the country to manage geopolitical risks. The trust’s top holding is Waste Connections (US:WCN), which provides waste collection services for commercial, industrial and residential customers. 

The focus on quality companies does mean the trust could underperform during a short-term growth rally that favours speculative, unprofitable companies – as happened at the end of 2023 – but it should hold up better during times of economic stress. Managers have noted that small-cap benchmarks have recently grown more economically sensitive, and stressed their preference for “cyclical businesses that have an excellent chance of driving to demonstrably higher highs and higher lows through the cycle”. 

Performance wise, the trust’s long-term track record is less than great, but the Brown Advisory team, which has a lot of experience and a solid track record, only took over from previous manager Jupiter in April 2021.

Since then, the ride has been bumpy, but the trust’s eclectic, quality-focused portfolio looks appealing for adventurous investors in today’s climate. The managers argue that the flow into passive strategies should increase inefficiencies in markets, giving active managers even more opportunity to exploit them. However, this also means that short-term market movements are increasingly driven by macro sentiment, rather than quality characteristics. The rally earlier this month was an example of that.

The trust is trading at a discount of around 11 per cent. If small caps do rally further, this should help boost returns and give this unloved area a new lease of life. There is no guarantee that this will happen and nobody has a crystal ball to predict when. But for investors looking to diversify away from the famous tech giants, BASC is a compelling option.