The opportunity in smaller struggling companies

As smaller companies valuations struggle BASC’s risk-aware approach to growth investing looks timely…by Alice Rigby

 
When it comes to US smaller companies, two equal but opposite truths have long held fast. The first is that smaller companies have historically outperformed their large-cap peers. The second is that retail investors tend to be underweight small and even mid-cap stocks within their portfolios.

Given the former, it makes little sense that investors have smaller allocations relative to the benchmark. However, their particular reticence over the last few years has followed some logic. As larger-cap equities experienced dizzying valuation growth in the late 2010s, their smaller cap peers struggled to keep up and in early 2020, the performance of the S&P 500 (a proxy for larger companies) overtook that of the Russell 2000 (a small-cap proxy) for the first time since the early part of this millennium.

Furthermore, as the US moved closer to an anticipated economic downturn through to the end of the COVID-19 pandemic, investors worried that stretched smaller businesses would struggle to survive and their performance again lagged behind large caps.

It is this latter concern – outsized riskiness relative to larger peers – that has tended to discourage investors of all types from allocating ‘properly’ to smaller companies. Yet, as we have already touched on, this means they could be leaving significant returns on the table. Small caps have outperformed larger cap peers in general over much of the last two decades and the best of these themselves grow into companies with much larger valuations than they began with. Theoretically, there is a much longer growth path available to a smaller company.

Compellingly, it is also worth stating that while US smaller caps have historically fallen in years marked by an economic or broader market decline, notably 2002 and 2008, their dud years have almost always been followed by outsized returns. Or to put it another way, smaller caps (like growth stocks) are especially punished on the way into a recession, and those that survive (this being the major risk to bear in mind) can be more richly rewarded in performance terms on the way out of one.

While this complicated picture suggests that investors should seriously consider the return potential on the table with smaller companies, the inherently greater risks attached to them means that selectivity is vital. But not all smaller companies fund managers are made equal. For Chris Berrier, manager of Brown Advisory US Smaller Companies (BASC), applying a risk-conscious approach to smaller companies investing makes sense.

By employing his signature ‘3G’ lens, which he and the wider Brown Advisory team have been applying to small caps for 17 years, he seeks to avoid the kind of overpriced and overhyped names that are sometimes mistaken for the typical smaller company.

The three Gs – growth, governance and go-to-market – essentially mean that the team looks for real, organically-growing opportunities, which are well executed and running with a strong financial profile, adding to revenues without adding significant costs. This focus on genuine, measurable growth means that the team should steer clear of the value traps that have gained particular favour in the value rally over the last year.

Over the long term this approach has proven successful; although, as Brown Advisory took over the management of BASC in April 2021 as both growth stocks and smaller companies fell out of favour, it has been a tough time to apply this lens to the portfolio. Nonetheless, with smaller companies valuations at a discount to their long-term average, there is notable potential for an uprating.

As the economic picture continues to evolve, the through-the-cycle benefits of actively considering smaller company-specific risks, while focusing on businesses generating strong growth, should become more apparent.

As the US has tentatively staved off a recession – at least for now – the widespread collapse of smaller companies anticipated by the market, which has driven valuations so low, appears less likely than those valuations would suggest. With that in mind, investors could start to consider an allocation to US smaller companies and the risk-aware, growth-oriented approach of BASC.
 
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Disclaimer

Disclosure – Non-Independent Marketing Communication

This is a non-independent marketing communication commissioned by Brown Advisory US Smaller Companies. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.