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Small companies, big opportunities in the US

President Trump’s pro-growth agenda, centred on fiscal stimulus, repatriation and de-regulation, should accelerate the US economy in the coming years. Nevertheless, his more measured recent speech to Congress was perhaps the first acknowledgement that the implementation of these policies will likely take time and require Republican endorsement.

Mindful of this, it’s important to focus on pre-existing economic fundamentals as much as fiscal promises when looking to invest in the US. Domestically-focussed small and mid-cap companies are well positioned to continue to benefit from a healthy and improving US economy alongside any fiscal policies that may take time to come through.

A fundamentally strong economy

In recent months, discussion regarding US markets has focused on the support that President Trump’s economic policies could offer. On the campaign trail, Trump suggested that he would lower corporate taxes and increase fiscal investment in infrastructure to support US businesses and economic growth. The prospect of these policies prompted a rapid rise in markets on the President’s election.

However, the market’s focus on Trump’s policies has somewhat overlooked the existing economic strength in the US. The economy has been improving for over five years. Unemployment has declined rapidly since 2010, to a historic low of 4.7%, while consumer confidence has followed a steady upward trajectory since 2012 and is accelerating as wages rise. Meanwhile, small business sentiment spiked last year on the expectation of Trump’s promise of deregulation and has been gradually improving since 2012.

While Trump has acted as a lightning rod for investors’ improved economic sentiment and could fuel growth in the US economy, there is justification for economic optimism even without the full spectrum of policies he has proposed.

The advantages of smaller businesses

With the US economy expected to continue its upward trajectory, it is domestically exposed businesses that should be the largest beneficiaries. Here, small- and mid-cap investors have a clear advantage. US SMID stocks typically earn 70-80% of their revenue domestically compared with 50% for large caps, so should benefit considerably from any enhanced US economic growth.

A significant proportion of US SMID companies pay the full 35% corporate tax rate so should see earnings rise disproportionately from any reduction in corporate taxation versus their larger counterparts, many of whom already enjoy favourable tax rates. Further, the repatriation of cash should encourage increased M&A activity, with SMID companies the likely targets.

Small and mid-cap companies have historically outperformed the broader market in periods of rising rates, in particular the early stages, which tend to coincide with strong GDP growth and a benign economic backdrop, a context we are currently operating in.

Hermes US SMID: accessing the opportunity

While the US SMID market is attractive, careful stock selection remains key. At Hermes we look for quality companies with high barriers to entry, a durable competitive advantage and that can be bought at a discount to intrinsic value. Importantly, for us, this focus on quality does not mean our portfolio consists solely of defensive stocks: we are willing to buy cyclical stocks if they meet our quality criteria.

With this in mind, we have recently increased our positions in two sectors we believe will flourish given the improved economic backdrop. The banking sector should benefit from rising rates and improving consumer sentiment. Meanwhile, industrial stocks should benefit from an increase in capital investment, infrastructure stimulus and, more broadly, inflation.

Our focus on quality and selectivity means we maintain a relatively concentrated portfolio. Our investors are exposed to what we believe are the very best opportunities in the market. Our emphasis on the durability of a company’s competitive advantage results in longer holding periods of, typically, 3-5 years, an approach that has allowed us to outperform through the market cycle. The Strategy has outperformed the Russell 2500 over 1, 3, 5 years and since launch (1) and over the same periods it has sat first quartile against its peer group. (2)

  1. Source: Hermes at 31 December 2016. Performance shown net adjusted for 75bps of fees in US dollars. Past performance is not a reliable indicator of future results.
  2. Evestment as at 30 September 2016.
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