US equities: is it time to ditch large caps and invest in smaller companies?, January 2023

Having led the rest of the world for most of the past decade, US equities entered a bear market last year. Rapidly rising inflation and an equally aggressive Federal Reserve response in rising interest rates both took their toll on investor sentiment. Larger companies and the big tech names in particular felt the pain of the move to a ‘risk-off’ environment. The S&P 500's performance in 2022 was, in fact, its seventh worst since inception and the third worst since 2000*.

A slowing US economy

The next Fed meeting is later this week. Analysts are expecting another rate rise of 0.5% - and hoping for a lower 0.25%. The latter would be seen as a reprieve because, according to Rathbones, several signs suggest that US households and businesses are beginning to rein in spending as higher costs and higher borrowing costs start to bite.

“Retail sales dropped 1.1% in December compared with November, the biggest fall since the previous Christmas trading season,” the company said. “Not only that, but the steep drop would have been greater if November’s sales weren’t worse than previously thought. To top it off, retail spending has now declined in three of the past four months.

“Also, US trade with the rest of world dipped significantly in November, with imports especially weak (-6.4% on the previous month). Falling imports could signal lessened consumer demand in the US.

“Taken together, the economic data confirm that rising interest rates are beginning to take a toll on the US economy beyond just the most rate-sensitive sectors. There's been a lot of talk about a soft landing recently, but we still think a recession is the most likely outcome for 2023**.”

How will US equities perform in 2023?

Franklin Templeton portfolio manager Scott Glasser believes 2023 will be a tale of two halves for US equities. The first will favour companies with solid balance sheets, durable cash flows and dividends – often in value oriented sectors. However, once investors feel the bear market is over, we may see a switch to small-caps and other higher risk stocks^.

Rupert Rucker, investment director, Schroder US Mid Cap fund, agrees. “What has worked in last 10 years and what will work in the next 10 years is very different,” he said.

“Ten years ago – right up until 2021 - the best decision anyone could have made would have been to invest in the S&P 500,” Rupert explained. “The market was driven higher by the FAANG stocks to such an extent that by last year there were imbalances in both the S&P 500 and the Nasdaq not seen since 1999. A handful of companies accounted for about 35% of the index of the world’s largest economy. That’s quite some concentration!

“Today, some sea changes are underway – not only will inflation remain higher (an environment that statistically favours US smaller companies) but the US government and economy is transferring away from globalisation and extended supply chains and bringing things back onshore or closer to home. Three acts have also been passed – one for infrastructure, one for chips and science, and one for inflation reduction – which are now providing billions of dollars’ worth of incentives for companies to manufacture onshore. This is a situation that favours mid and small caps which are more domestically focused and derive 80% of their revenues from the home market.

“The icing on the cake is that valuations in the smaller end of the US market are far more compelling. 10 years of S&P 500 dominance means small and mid-caps are the cheapest they have ever been vs large caps. And if the market goes the same way as it did in 1999, history suggests that the S&P could trade sideways for some time and small caps outperform,” he concluded.

Time to favour small caps?

So, should investors ditch US large caps and instead invest in smaller or medium-sized companies?

“I wouldn’t sell large caps at this point,” said Rupert, “but I would certainly consider diversifying more into mid and small caps. The US is actually coming out of the political crisis very well – it’s the biggest oil exporter and LNG exporter in the world and has the extra impetus of the government incentives I mentioned earlier. As long as unemployment doesn’t become a huge problem – which I think is unlikely in this recession – the US consumer will stay relatively strong and again is mainly domestic.”

In its chart of the week, Goldman Sachs Asset Management also pointed out that while “episodic volatility, lack of earnings growth, and a high cost of capital may pose headwinds for US equities in 2023, here is a silver lining: since 1928, the index has only delivered consecutive years of negative returns eight times. History may be on investors' side as positive S&P 500 annual returns have followed a down year more than two-thirds of the time.”

Source: Bloomberg and Goldman Sachs Asset Management. As of December 31, 2022.

Funds to consider

Those considering diversifying their US equity holdings could consider a multi-cap fund like AXA Framlington American Growth or Brown Advisory US Flexible Equity.

The AXA Framlington American Growth fund invests in innovative companies with unique brands and intellectual property and while it tends to have a significant weighting to mid-cap, will also invest in small and large companies.

As the name suggests, the Brown Advisory US Flexible Equity fund is completely flexible, and the manager is free to select companies from across the market cap spectrum. He primarily seeks out undervalued medium to large improving businesses, which rewards the fund with good liquidity (ability to buy and sell easily) and decent growth prospects.

Those looking for more specific exposure to small and medium companies could consider the Schroder US Mid Cap fund or the T. Rowe Price US Smaller Companies Equity fund.

Run out of New York by Bob Kaynor, Schroder US Mid Cap has a focus on small and medium-sized companies, with a diversified set of return drivers, in order to dampen the risk of the overall portfolio. 

T. Rowe Price US Smaller Companies Equity fund invests in both growth and value opportunities in the small and mid-cap space. The manager will allow his winners to run as long as he still believes there is a return opportunity. As such, the portfolio is likely to have more of a mid-cap bias than its peers and it will also invest in areas such as biotech, which other generalist funds often avoid.

*Source: Goldman Sachs Asset Management, 9 January 2023
**Source: Rathbones, Review of the week: Bonds vs Fed, 23 January 2023
^Source: Franklin Templeton: 2023 US Equity Outlook: Patiently Waiting for a durable bottom

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and do not constitute financial advice.