Darius McDermott, managing director of Chelsea Financial Services and FundCalibre, considers whether there is scope for a prolonged recovery in US small caps, or if in fact, investors have already missed the boat.
Smaller companies across the globe have been in the doldrums for a number of years as rising rates have made it more expensive to borrow to finance growth; while higher volatility has raised liquidity concerns.
The squeeze has been palpable – at one point last year global small-caps accounted for only 4% of the total valuation of the global stock market, a 50-year low and well below the average which has been closer to 7-8%.
But we have seen green shoots of hope as falling rates – coupled with increased M&A activity – have increased optimism that 2025 could be a more profitable year for small-caps. The two standout regions from a valuation perspective are the UK and Europe, both of which are now trading at significant valuation discounts on their forward P/E ratios, relative to their own history*.
But what about the world’s largest economy? The case for US small-caps is just as interesting, but the narrative is slightly different in a sense that although they are not cheap versus their own history, they look incredibly cheap compared with US large-caps*.
Small-cap started to outperform in the US in the second half of 2024, with the S&P SmallCap 600 Index approximately doubling the return of the S&P 500**. There were in fact two rotations in the second half of last year, with rate cuts favouring the sector in July, while we also saw a surge at the back end of 2024 immediately after the election, demonstrating strong investor confidence in small-cap opportunities under the Trump administration.
The question is whether investors have already missed the boat or whether there is scope for a prolonged recovery?
Domestic tailwinds
Artemis US Smaller Companies fund manager Cormac Weldon says incoming President Donald Trump has inherited a robust economy, with inflation contained and the Fed on a rate-cutting cycle; while the post-Covid recovery and the recalibration of supply/demand dynamics should present a number of opportunities for smaller companies***.
There is also the commitment to Government infrastructure spending through the $1.2 trillion Infrastructure Investment and Jobs Act – boosting the likes of public transport and improving high-speed internet access. With an 85% correlation to capital expenditure growth****, small-caps with their primary domestic focus, are well-positioned to benefit from anticipated increases in domestic investment and infrastructure spending in an ‘American First’ mantra, driving future growth potential.
Schroder US Mid Cap manager Bob Kaynor says: “Capex has been increasing for a number of reasons, including the shift to automation, as companies look to lower costs and stay competitive, and the financial support the government is providing key sectors like the semiconductor industry and renewable energy sector through the CHIPS Act and the Inflation Reduction Act.”^
As Weldon points out, the build-out of AI infrastructure (such as data centres) shows no signs of slowing – the bigger risk for companies is underspending rather than overspending****. It will require much more than just chip-providers, with the likes of thermal management solutions to manage the heat generated by those chips or the likes of data storage and software development. Small-caps are likely to be leading players in these sub-industries.
We’ve also seen rising M&A activity in North America through the first three quarters of 2024 – almost surpassing the deal value for all of 2023. Falling rates and improving economic conditions should see this continue into 2025. Mid and small-caps are also key players in the services sector, an area which still accounts for almost three quarters (72%) of US GDP^.
The Trump-fuelled revival
The expectation is that Donald Trump will turbo-charge the rally in the US small-cap market. History tells us that the first year of a new US President is usually a good one for small-caps, with the Russell 2000 producing an average return of 15.6% each time this has happened since 1979****.
Trump is expected to ease regulations and introduce corporate tax cuts, which would benefit small-caps, which usually face higher compliance costs and pay closer to the full US corporate tax rate. We also have tariffs and the move to onshoring, both of which are linked to a degree. My view is Trump will pull back from some of his more aggressive tariff calls, but will still use it as a tool to make deals. This brings me to onshoring and reshoring, which benefits many small US companies that are replacing global competitors as the suppliers to large US firms.
Janus Henderson portfolio manager Jonathan Coleman says: “An increasing tariff regime creates opportunities for companies with greater exposure to the US economy. Since small-caps generate less revenue from outside the US than their large-cap peers, potential trade barriers could further enhance their attractiveness.”**
Valuations are still attractive
It is true valuations are more attractive for the likes of European and UK small-caps. However, in the US small-cap P/E multiples look relatively low compared to large caps (11% below average). Large vs. small-cap performance is cyclical in nature – with outperformance periods ranging between six and 14 years – we are currently in the 13th year of outperformance for large-caps**. A recent update from BNP Paribas indicated that analysts believe robust earnings growth of over 30% is possible for US small-caps in 2025 and 2026^^.
While US small-caps are trading roughly in line with their long-term average, there are plenty of reasons to suggest further growth from here. As mentioned, this is no ordinary cycle and small-caps can benefit from major trends like AI and re-shoring; while a pro-business president like Trump will be determined to make life easier for these burgeoning businesses. All this against a backdrop of the Fed pivoting towards monetary easing.
Small-caps are the realm of the active investor, and the US is no different. For example, 36% of Russell 2000 constituents remain unprofitable**. Investors may want to consider pure plays like the Artemis US Smaller Companies or Schroder US Mid Cap fund (which invests in small and medium-sized companies). While those looking for exposure to small-caps in a wider portfolio might consider the likes of the abrdn Global Smaller Companies fund (which has 50% in the US)^^^ or a couple of multi-cap US funds like Comgest Growth America or Premier Miton US Opportunities.
*Source: JPMorgan, Guide to the Markets, 31 December 2024
**Source: Janus Henderson, 17 December 2024
***Source: Artemis, 3 December 2024
****Source: Neuberger Berman, December 2024
^Source: Schroders, 18 December 2024
^^Source: BNP Paribas, 15 November 2024
^^^Source: fund factsheet, 30 November 2024
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
