The trebling of the S&P 500 index in the last ten years has left the US market accounting for 57% of the MSCI All Countries World index. Much of this outperformance is justified by strong domestic growth, international expansion, rising margins, lower taxes and, above all, America’s record of innovation – but, arguably, not all of it. The earnings multiple of the World index, based on forecast earnings for 2021, stands at nearly 20 but that of the S&P 500 is at 22.5, the highest since 2001. The rest of the world averages out at 16.
Value in the wider market
That has prompted many to conclude that the US market is overvalued. Priyesh Parmar of brokers Numis, however, points out that smaller companies have been left behind. Though the small-cap Russell 2000 index has been outperforming since November, it trades on a discount to the S&P of over 20%, the lowest rating for nearly 20 years. By the standards of the last ten years, smaller companies are moderately expensive but not nearly as expensive as larger companies, while interest rates and bond yields are much, much lower than their historic average – a backdrop that would tend to justify high valuations. Given the long term record of small-cap outperformance globally and in the US, this looks like an anomaly and, Parmar believes, the £250m JPMorgan US Smaller Companies Trust (LSE: JUSC) is the best way to take advantage of it. JUSC is managed by Don San Jose, but his style is far removed from that implied by his swashbuckling name. San Jose looks for “quality companies with a sustainable competitive advantage and a high return on capital”. There is a strong valuation discipline, so the portfolio of 81 holdings has a significantly lower valuation than the index, despite higher earnings growth and a higher return on equity.
With 85% of the portfolio in companies with a market value above $2bn, San Jose is invested at the larger end of a small-cap universe of 2,000 companies. No holding is worth more than 2% of the portfolio, the sectoral composition of which differs markedly from the S&P 500 and the Russell 2000.
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Exposure to technology at 13% is a little below the index but healthcare, at 12%, is well below. There is no exposure to biotechnology (“no consistency of earnings”) nor to energy. Instead, San Jose is overweight financials and industrials. Annual portfolio turnover of 20% is not high and it has clearly been no impediment to performance.
Since his appointment in 2008, San Jose has outperformed the Russell 2000, returning 17.8% a year against the index’s 14.8%. Over one and five years, performance kept up with the outperforming S&P 500. Should small caps outperform over the next few years, JUSC’s performance can be expected to move well ahead. Performance is also well ahead of the £160m Jupiter US Smaller Companies Trust (LSE: JUS) but the latter’s management has recently been moved to the well-regarded Brown Advisory so competition is likely to stiffen. While JUSC trades on a premium to net asset value and is issuing shares, JUS is still on a 10% discount.
Time to catch up
If the valuation of the S&P 500 is not to get dangerously ahead of earnings, it may need to trade sideways for much of 2021. But in the meantime there is plenty of scope for a small-cap catch-up, particularly given the enormous pent-up demand in the US economy. As Ed Yardeni, of Yardeni Research, shows, forward earnings estimates for mid and small caps are rising at a record pace and are poised to reach all-time highs, yet the tiddlers have seen nothing like the rerating of the S&P 500. JUSC is an ideal way to profit from the opportunity: a well-managed trust at the neglected end of a core market with great prospects. The only question is why is the trust so small? It should be much larger.
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