We know that UK-focused smaller company trusts have been suffering recently and one of the reasons cited is that UK-based investors are reducing their allocation to the domestic stock market within their portfolios.

The destination for their money is often thought to be the US, which dominates global indices, but this interest is not showing up in the ratings of the two small-cap investment companies focused on the US – Brown Advisory US Smaller Companies (BASC ), which trades on a 12% discount, and JPMorgan US Smaller Companies (JUSC ), priced at 10% below net asset value (NAV).

In part, this is because – as in the UK – small-cap stocks have lagged larger companies by quite a wide margin. In sterling terms, over 10 years to the end of March 2024, the Russell 2000 Smaller Companies index has produced 163%, about half the 322% return on the S&P 500 index.

It probably also does not help that both funds have underperformed the Russell index. Over the year to 31 March 2024, BASC returned 10.5% in NAV terms and 13.4% in share price terms. For JUSC the equivalent figures were 9.5% and 3.7%, while the Russell 2000 returned about 17%.

The oft-cited ‘Magnificent Seven’ may now look more like a Magnificent five and a bit given Tesla’s shares have slumped and Apple’s gone sideways over the past year. Nevertheless, a large part of the problem has been the intense focus on AI-related stocks. With less representation in this area, small companies are being neglected and now stand close to a relative low point in respect of their valuations versus those of large-cap stocks. Consequently, US small-cap fund managers are bullish about the long-term prospects of their portfolios.

BASC’s fund manager is Christopher Berrier. He has run the portfolio for three years, having been appointed on 1 April 2021. The three-year figures are closer to the benchmark (2.1% in NAV terms versus 2.9% for the benchmark), but investors will have hoped for more. When it was appointed, Brown Advisory’s equivalent open-ended fund had a great long-term track record of outperformance.

The investment approach is designed to produce a portfolio that will look quite different to the benchmark index. There is a focus on durable growth, sound governance, and scalable go-to-market business strategies. When he makes an investment, Berrier thinks about where the company will be in two, or three, years’ time. Unprofitable companies rarely make it into the portfolio. I think, if it can be pigeonholed, this makes it more of a quality growth strategy.

As we know, growth and small cap had suffered in an environment of higher interest rates – US smaller companies are more likely to have floating rate debt than their larger counterparts. However, BASC says that the rally that occurred on the back of hopes of rate cuts in the fourth quarter of 2023 was focused on lower quality stocks, and this is why it has been left behind in the past year.

This pattern has been repeated in the UK, where quality focused small cap growth funds such as BlackRock Throgmorton (THRG ) and Montanaro UK Smaller Companies (MUT ) have lagged turnaround specialists such as Strategic Equity Capital (SEC ) and value players like Aberforth (ATS ).

JUSC also has a quality-focused approach. Its managers said recently that they have been doubling down on this. Selling lower conviction positions and focusing on businesses with high returns on equity and strong earnings growth.

They think that earnings growth will be more of a driver of returns in 2024, as the fixation on AI exposure and macroeconomic conditions eases and investors think more about fundamentals.

Unfortunately, there is no value play available in US small caps within the London-listed investment companies market. That was the role BASC played before Brown Advisory took over from Jupiter’s Robert Siddles. There is a more aggressive growth fund, however, within the global smaller companies sector.

Edinburgh Worldwide (EWI ) has over 75% of its portfolio invested in North America. Clearly, the story is distorted by the trust’s 26% unquoted exposure at 31 March. However, its returns are still very much dominated by the macroeconomic picture. Things improved towards the end of last year, but the NAV and share price have been hit hard recently by the disappointing US inflation figures and the associated fears of a delay to interest rate cuts. The effect on EWI has been much more marked than on JUSC and BASC.

It makes sense that the valuation gap between large and small US stocks will narrow in time, though whether that comes in the form of falling large-cap valuations or small-cap outperformance is harder to call. The JUSC team points out that over the period following the end of the dot.com boom, small company stocks outperformed by 1-2% for several years in succession. That looks like a veiled comment on AI stock valuations to me but is perhaps encouraging, nonetheless.

James Carthew is head of research at QuotedData.

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