By Robert Maharajh Analysis of offshore funds investing in US small caps shows fund managers in a...
By Robert Maharajh
Analysis of offshore funds investing in US small caps shows fund managers in a relatively positive mood, believing small caps are set to outperform their larger counterparts.
One of the better performers over three years has been the Aberdeen Global American Small Companies fund. This invests in US companies with a market capitalisation of around $1bn, with around 50% of the portfolio in stocks smaller than this and the other half in those slightly larger. The portfolio, which is benchmarked against the Russell 2000, generally contains between 40 and 60 stocks.
Alex Ingham, fund manager, focuses on good long-term growth stories, with the emphasis on bottom-up stock selection.
He said: "It is more or less impossible to take a top-down approach with this asset class because of the nature of the index. The top 40 stocks in the S&P 500 account for around 40%-50% of the index, whereas in the Russell 2000 it takes around 500 stocks to account for 40% of the overall market capitalisation."
Nevertheless, Ingham operates according to certain risk parameters. "We can be no more than 10% over or underweight the index in sector terms, and a single stock cannot be more than 4% of the portfolio. This cap is particularly important when dealing with smaller companies a profits warning that might see a larger company fall off 20% could see a smaller company's share price halved."
Clearly one of the most important trends over the past year has been the fall-off in technology. "We were late in going underweight this sector. Ideally we would have done so last April, but in fact we cut our weighting around two months ago. We now have a market weighting in tech."
Ingham is overweight financial services. "Falling rates should favour interest-rate sensitive banks, mortgage insurers and real estate investment trusts which should see a yield pick-up as long-term rates decline."
He is also positive on consumer discretionary stocks, another play on falling interest rates, although he has recently taken profits, feeling the sector has run far enough for the moment.
Another overweight position is healthcare, although these stocks have not performed as well as hoped so far this year a result, Ingham believes, of having been overbought last year as investors fled from the tech sector.
Energy stocks are also an important part of the portfolio. He said: "We hold two independent power producers, Synergy and NRG energy. One of my favourite stocks in the portfolio is Shaw group, which makes the pipes that lead into power plants, and which has a $3bn order backlog. The company has a proprietary technology which enables it to make pipes with less welding and fewer seals.
"As a result, its products last longer and need less maintenance. This is the perfect example of the kind of stock we look for it is growing well, is attractively valued and is in an area where there are high barriers to entry."
Ingham believes the recent outperformance of smaller companies relative to their larger counterparts is because the market has shifted away from favouring very large companies which are trading on high valuations as a result of having been overbought for the previous two years.
"The market as a whole is much more valuation-sensitive now. With small caps being so much cheaper than large caps, the balance is being redressed.
"With considerable uncertainty surrounding the earnings outlook right across the market, investors are realising that they are better off buying the cheaper companies which will not be de-rated so dramatically if they disappoint on the earnings front."
Another strong performer is the Deutsche Bank American Enterprises fund, run by Audrey Jones, managing director of Deutsche's US small and micro-cap equity group.
The fund is run in a growth style with a bottom-up focus and is diversified across a wide spectrum of industries and sectors. Its aim is to outperform the Russell 2000 by around 300bps over a full market cycle.
Jones said: "The universe contains more than 4,500 companies. The question of how to attack this market and distill best ideas into a portfolio of 60 or 70 stocks is a difficult one.
In practice, a large-cap manager can construct a portfolio by making almost binary decisions, weighing one stock against another: do I want to hold BP, Exxon, WalMart or Kmart? By contrast, a stock that we pick has to be weighed against around 50 peers. This is a very labour-intensive task and we take a team approach."
Managers and analysts are divided by sector and do fundamental as well as comparative analysis.
"We work very much from the ground up. Clearly, after earnings are reported, the value is very much already in the price."
On a sectoral basis, the fund can be plus or minus 50% of the benchmark weight. Jones said: "There are times when we take decisive moves against the benchmark. The most important recent move was underweighting technology we began to cut our allocation there last June, moving mostly into healthcare, although we also added to credit-sensitive holdings as well as to energy and transport.
"We are now overweight consumer and credit-sensitive areas.
"We are now seeing a period of extended outperformance for this asset class. Relative valuations are attractive and we are seeing inflows as fund managers realise that they can buy a higher rate of growth for lower multiples."
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