With more confidence in the outlook (chiefly as a result of falling interest rate expectations), investors were willing to look again at smaller companies.
Optimism remains
Fund managers are more optimistic about this part of the market than they are about the forgotten 493.
Hugh Grieves, manager of the Premier Miton US Opportunities fund, says: “Markets didn’t have much confidence in 2023. While equities didn’t have a bad year, the real stand-out was the magnificent seven.
"People were worried that higher interest rates would send the economy into a tailspin. These companies are big index stocks, they’ve got lots of cash and big margins. They were seen as a safe place to be. But now everyone is on one side of the boat.
“Mid and small-caps are trading at a discount to the wider market, when they usually trade at a premium. I can’t remember a time in my career when they have traded at this scale of a discount.”
He notes there is a danger that the remainder of the S&P 500 will be dragged lower if there is any weakness in parts of the magnificent seven.
For small and mid-caps, by contrast, valuations are low and they have been substantially overlooked: “If the US escapes a recession, as I think it will, there is an interesting opportunity.”
Curt Organt, portfolio manager on the T Rowe Price US Smaller Companies Equity Strategy, agrees: “For US smaller companies, which have borne the brunt of heightened risk aversion in recent years, this marks a significant turning point. As risk appetite returns, and fundamentals once more prevail over sentiment, the extreme relative valuation discount of smaller companies looks increasingly attractive.”
He adds the discount of smaller companies is at a level “not seen in decades”.
He also notes the small-cap sector has undergone a lot of self-help: “US companies have also moved quickly to downsize or refinance their debt since the pandemic, resulting in generally healthier balance sheets, more cash, and less exposure to interest rate fluctuations.”
The domestic focus of US smaller companies could become an advantage if the US economy has a soft landing, or even no landing at all.
Organt says: “Smaller companies offer a much more diversified exposure to the vitality of the US economy and a different risk profile to large-cap investing. The domestic bias of smaller companies, and more balanced exposure at the sector level, means they are often better positioned to benefit from changing trends in the US economy.”
It is not always clear when a sector is about to turn, but there is more sign of it among US smaller companies than elsewhere.
