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America: land of opportunity for SMID investors

The fiscal expansion and deregulation expected under incoming US President Donald Trump, plus the concentrated domestic exposure provided by smaller companies, are convincing reasons to look down the market-cap spectrum for opportunities to outperform.

All change: a new investment environment dawns

The dramatic shift in US leadership has fundamentally changed the outlook for domestic small- and mid-cap (SMID) stocks. The consensus view that the economy was locked in a low-growth, low-inflation mode should be revisited. Markets have responded positively to pro-growth policies put forward by Trump, such as spending $1tn on infrastructure and slashing the corporate tax rate from 35% to 15%.

Such policies are likely to proceed given the Republicans’ control of Congress, and in time should boost growth and inflation in an economy that was beginning to accelerate – US real GDP increased at an annual rate of 2.9% in Q3, more than doubling the pace of growth recorded in Q2.

Trump’s policies mark a change in the efforts of US authorities to stimulate growth. The Federal Reserve’s use of monetary policy since the financial crisis, which has driven prices for income-producing assets higher but had a limited effect on the real economy, is now likely to be replaced by fiscal stimulus.

Treasuries have already sold off on the near-term prospect of the Fed raising the official interest rate in December and the long-term risk of higher inflation (see figure 1). We believe that this is the first phase of a wider rebalancing by investors away from inflation-sensitive bonds towards pro-growth equities.

Figure 1. End of an era: long-term US bond yields spike on growth expectations

Source: Bloomberg as of 23 November 2016.

Next year, the Fed is likely to hike interest rates two or more times, in addition to the probable increase in December. Given that small-cap stocks tend to outperform large caps during tightening cycles1, now is an opportune time for investors to consider establishing or increasing their exposure to robust smaller companies that are prone to benefit from the new investment environment.

For growth, look down the market-cap spectrum

This changing backdrop suggests that the currently popular positioning in large-cap defensive stocks may no longer be a winning strategy. We see two clear reasons why smaller US companies are now particularly attractive relative to large caps: industry exposures and valuations.

US SMID stocks typically have a 70% to 80% exposure to the domestic economy, compared with 50% for large caps. Within this, smaller companies are substantially better represented in the industrial and financial sectors, and should generate stronger relative earnings momentum due to increased infrastructure spending and the margin-boosting effects of a steeper yield curve and higher short-term interest rates (see figure 2).

Figure 2. Favourably exposed: sector weightings of Hermes US SMID and the Russell 2500

Source: Bloomberg as at November 2016

Given these powerful fundamental drivers, US SMID stocks represent good value relative to large caps. Their current premium of a 1.1x price-to-earnings multiple over large caps is lower than the long-term average of 2x, suggesting that the market has not fully factored in the strength of the growth outlook for these companies2.

In contrast, large-cap defensive stocks appear expensive relative to small caps (see figure 3). Persisting with an allocation to these businesses at the expense of smaller companies may incur significant opportunity cost.

Figure 3. Valuations: large caps v small caps in the US

Source: “US equity strategy: Valuation rundown,” by Lori Calvasin et al. Published by Credit Suisse on 14 November 2016.

Where top-down analysis meets bottom-up opportunity

Such top-down considerations are integrated into our bottom-up analysis of stocks, and we currently hold many high-quality businesses that are poised to benefit from the new investment environment. They include:

  • MSC Industrial, a distributor of metalworking, maintenance and repair supplies, which should benefit from a recovery in industrial activity after two tough years. Rising inflation would provide an additional tailwind
  • Signature Bank, a position we have recently increased amid market concerns that the lender was exposed to credit losses – we judged that its valuation had already been adjusted for this and that the company had largely increased its reserves. Recent research shows that the upside potential for banks could result in a stock-price increase of 48% for Signature Bank

US SMID stocks: now is the time

In the year to date, the Hermes US SMID Equity Fund has outperformed its benchmark, the Russell 2500, by a net 5.5% in US dollar terms. The Fund also generated net annualised outperformance of 9.6% and 8% in US dollar terms for the one- and three-year periods ending 31 October3.

These returns place the Fund first in its Morningstar peer group for the one-year period ending 30 September and seventh over three years4.

We focus on identifying attractive entry points into high-quality businesses benefiting from durable competitive advantages. We believe that our proven stock-picking approach, combined with the favourable conditions for US SMID companies, present a compelling argument for investment.

1 “How to invest as interest rates rise,” by Joe Light. Published in The Wall Street Journal on 3 January 2014

2 Source: Bloomberg as at 23 November 2016

3 Source: Hermes as at November 2016. Performance shown is the Hermes US SMID Equity Fund in USD, net of fees. The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. Past performance is not a reliable indicator of future results and targets are not guaranteed.

4 Source: Hermes as at November 2016. The peer group is the EAA OE US Mid-Cap Equity Morningstar Category. 

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