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JPMorgan: why US small caps continue to have an edge

2 December 2019

Don San Jose, fund manager of JPMorgan US Smaller Companies, says companies in the Russell 2000 index offer better value and more diverse growth opportunities than large-cap S&P 500.

Don San Jose, portfolio manager of JPMorgan US Smaller Companies (JUSC ) investment trust, on where to find value and good growth in the Russell 2000 index.

Whilst trade tensions continue to impact market volatility and sentiment, the strong performance in US equities provided both relief and hope to investors, who piled back into the market and drove the Russell 2000 smaller companies index up 17.2% over the first ten months of the year. Despite continued uncertainty, a strong focus on the fundamentals combined with a disciplined approach is why we think this strategy is a consistent winner.

The benefits for investing in US small caps are clear – it’s about finding high-quality companies with strong earnings growth and higher potential returns, in what can be an under-researched market. The average US small company has five or six analysts, whereas there are generally double that for larger companies.

This is what gives small-cap investors an edge – the ability to invest in undervalued, well-run businesses with a track record of value creation.

Diverse growth

Even though over the past two years the S&P 500 index of US larger companies has outperformed the Russell 2000, we still remain of the view that in the long-term small caps look more attractive when compared to their large cap peers.

All sectors of the Russell 2000 bar one, energy, have posted positive returns year to date through October, with technology, producer durables and materials & processing posting the best returns amidst ongoing market uncertainties.

We continue to find a great deal of opportunities in the consumer discretionary sector, which is also the driving force behind US economic growth, and where we hold a sizeable overweight position relative to the benchmark.

Within this sector we tend to be more biased towards leisure rather than retail companies, such as Brunswick (BC.N), manufacturer of marine engines & leisure boats, and rival Malibu Boats (MBUU.O).

Pool Corporation (POOL.O) is another great example of a high-quality company we hold. It is the largest wholesale distributor of pool equipment and supplies in North America. We have held this name for nearly a decade and we remain attracted to its unique combination of growth and defensibility, as most of its revenues comes from non-discretionary pool maintenance products.

As the market share leader in a niche market, Pool earns best in class margins. Getting pool supplies to site is more complex than many think, and Pool really delivers in excellence. We also appreciate the visibility of the business’ recurring revenues and remain confident in management’s strategy and the company’s fundamentals.

Even if we compare smaller companies to large caps, on a relative valuation basis the former look more attractive with various examples of companies that have compelling financial models we think can increase shareholder value.

One such example is Toro (TTC.N), a turf maintenance equipment producer also involved in landscaping and the manufacturing of snow removal equipment. Toro is one of our top holdings in the producer durables sector because of its strong competitive position with a brand built over 100 years and a history of innovation. The business has low capital intensity, with a strong balance sheet and high returns on invested capital.

Whilst various market uncertainties continue to loom and weigh down on business investment, companies with defensive business models have demonstrated steady revenue growth and margin expansion.

One such company is AssetMark Financial Holdings (AMK.N), a leading provider of wealth management and technology solutions to independent financial advisers and their clients. The platform enables advisers to outsource higher cost and specialty services that would otherwise require significant investments of time and money.

The company has strong recurring revenues with around 95% of fees based on assets under administration. The mission-critical nature of the service in client reporting, account opening, billing and compliance ensures high levels of retention plus high switching costs make clients even ‘stickier’.

It has a strong brand name in the business, with a compelling financial model, strong organic growth, and consistent free cash flow generation. We also believe the valuation is reasonable, especially given the financial sector’s maturity and broader concerns about credit risk and interest sensitivity at regional banks.

Own not rent

When looking at small companies, we find people talk about ‘renting in large caps but owning small caps for the long haul’. The current sentiment is indeed about focusing on the longer term, especially in times of heightened uncertainty.

Our analysis shows that long-term prospects still look good for US small caps, although the implications of US-China trade talks will be integral to investor sentiment and will likely continue to contribute to uncertainty.

Don San Jose and team won the North American Equities category this year’s Citywire Investment Trust Awards, their third consecutive win.

 

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