Sharing his latest insights with us, Jonathan Brachle, Investment Manager, JPMorgan US Smaller Companies Investment Trust , discusses the current market dominance of large-cap tech stocks, specifically the Mag7, and why it’s not only led to a polarised market, but also is making smaller companies an attractive alternative for diversification.
Investors often hear about the benefits of diversification, but sometimes market conditions make returns heavily reliant on a few big stocks. Recently, US tech giants have dominated the market, overshadowing other sectors. In 2023, the “Magnificent Seven” tech stocks contributed nearly 70% to the S&P 500 Index’s total return and made up over 15% of the MSCI All Country World Index (ACWI). After showing signs of broadening out in the first quarter, market leadership reverted to the handful of large cap growth stocks that had propelled the market higher over much of 2023. The extreme polarisation of the market is evident in the outsized contribution these “Magnificent Seven” tech stocks made to total returns. More than 60% of index returns over H124 came from these seven names. These seven stocks now represent over 30% of the entire index, a concentration not seen since the early 1970s.
For those looking to diversify their US equity exposure, there’s an attractive alternative: US smaller companies. Right now, US smaller companies are undervalued compared to their larger counterparts.
Historically, there have been cycles where small-caps outperformed large-caps and vice versa. Since 2012, large-cap companies have been in the lead, but signs suggest this trend might be reversing. The combined market value of the Russell 2000 Index, which includes about 2,000 of the smallest US companies, is currently less than that of Microsoft alone. This reinforces the severity of the polarization.
Lessons from history
Following the “Nifty Fifty” market of the early 1970s and the dotcom bubble of the early 2000s, the forward looking performance coming out of these periods has been favorable for US small caps for several years. In the 10 years following the Tech bubble, small caps outperformed large caps 8 out of 10 times and by over 400 bps per year on average, when we compare the Russell 2000 vs its large cap counterpart, the Russell 1000. Historically, small and large caps alternate leadership positions in decade-long increments, so this period of underperformance is not unusual.
Attractive valuations
Smaller US companies have historically traded at a higher price-to-earnings (P/E) ratio than larger ones.
Since the pandemic, the average P/E ratio for the Russell 2000 has been below its long-term average, now matching the S&P 500’s P/E ratio for the first time since 2001. This makes smaller companies attractive investments, offering value compared to both their historical norms and large-cap stocks.
Valuations remain attractive for small caps compared to large cap stocks. While the S&P 500 is trading at 21x Forward P/E, the Russell 2000 trades at only 14x Forward P/E (as of 30 June 2024). This valuation gap should attract investors looking to diversify away from the very concentrated top 10 stocks in the S&P 500.
Opportunities in smaller companies
The Russell 2000 offers investors a chance to invest in the heart of America. These small and mid-cap stocks are diverse and more domestically focused than the multinational giants at the top of the S&P.
As an asset class, the small cap universe is underexplored as they are far less researched relative to large caps. The average small cap stock is covered by 6 sell-side analysts, which compares to the average S&P 500 company at 19. This makes for a less efficient small cap market, and provides a greater opportunity for good active managers to find alpha opportunities. It’s thus no surprise that the odds of finding big winners in small caps is especially high. Besides providing important portfolio diversification, smaller companies typically outperform in the long run due to their longer growth runway.
However, the picture isn’t completely rosy for small caps. Thirty-nine percent of the Russell 2000 index is unprofitable, and small caps have a 4.6x leverage ratio on average. Disparities between market averages and individual stocks require active management to identify the winners and losers. Our investment process focuses on businesses with three key attributes: quality businesses, quality management, and trading at attractive valuations.
Companies such as MSA Safety are good examples of how to tap into this market. As global leaders in the development, manufacturing, and supply of safety products, MSA provide mission-critical and non-discretionary nature of safety products. This means that MSA tends to experience less cyclicality compared to many other industrial companies, with regular replacement of safety equipment often mandated by law. The company is profitable and requires limited capital investment, driving strong and durable cash flows.
Similarly, Encompass Health, the largest operator of inpatient rehabilitation facilities in the US, provides services which are largely needs-based. Patient volumes are non-cyclical and benefit from an aging population. The combination of steady revenue growth, attractive profit margins, and strong cash flows testifies to the quality of the business. We believe Encompass’ strong management team and attractive valuation make the stock an attractive investment.
What’s next for US smaller companies?
We expect the US economy to remain robust, benefiting consumer and business spending, which provides an attractive backdrop for small caps with their more cyclical sector exposures. Smaller companies also tend to have higher leverage levels, offering an earnings tailwind as interest rates are expected to move lower. Despite recent gains, the Russell 2000 Index is still 8% below its last high reached in November 2021, indicating significant room for growth moving forward. With a continuously strong US economy, small caps should perform well.
We believe that earnings will ultimately determine the sustainability of this rally. As earnings growth potentially broadens beyond mega-cap technology companies, the small cap sector could continue to outperform. Small caps are expected to grow EPS by 20% in 2024, compared to a 12% growth expectation for large caps.
We therefore remain constructive on small caps given their near-historic low valuations, the potential return to earnings growth after two years of declines, under-allocation by institutional investors, and the benefits from potential interest rate cuts by the US Federal Reserve.
