An investment idea in the US stock market

An investment idea from our experts: US stock market minnows

When it comes to investing in the US, investors are likely to be familiar with the most famous household names such as the big technology brands including Amazon and Meta, or the retailers such as Coca Cola and Nike.

However, opportunities also exist in the lesser-known, smaller companies that fall into a category called US Small and Mid-Cap (SMID). Small-cap companies are typically those whose total market value, otherwise known as market capitalisation, is between £100million and £2billion, and mid-cap companies are between £1billion and £5billion.

These businesses have been overlooked by investors for some years while the other parts of the market – particularly technology giants – have consistently hit the headlines.

But a recent cut in interest rates in the United States, as well as valuations that are seen by commentators as attractive, could lead to the SMID sector receiving more attention as investors start to recognise their potential as the giants of tomorrow.

AI has dominated investor behaviour in recent years

Large cap companies in the US, typically those with a market capitalisation of above $20 billion, have dominated stock markets since the latter stages of 2022. This dominance has been led by a small number of US technology-focused companies, often nicknamed the “Magnificent 7” – Amazon, Apple, Google parent Alphabet, Meta Platforms, Microsoft, Nvidia and Tesla.

The market believes that most of these companies are very well placed to benefit from the Artificial Intelligence (AI) boom . This theme has dominated the market in the last few years, with many companies now boasting about their future AI capabilities.

Different exposure

However, the SMID market in the US has not gained from this AI theme as much as large caps due to their lack of exposure to these giants. The US SMID market is diversified across a range of different sectors, such as mining, pharmaceutical and retail, with no one single sector being dominant. And as is often the case with smaller companies, their revenue is generated mainly from the US, their home market.

If US consumers spend more on buying a new house or renovating their current property for example, there are smaller US companies that that could stand to benefit. For example, housebuilding companies or DIY retailers selling paint and tools.

Valuations are supportive

Market commentators are increasingly suggesting that the broad market valuations of US SMIDs remain appealing. This means that investors believe they have a lower share price than their true supposed value. Such firms are said to offer value both in isolation, and relative to the larger companies that have dominated market returns in recent years. Some managers believe that this undervaluation is as large as has been seen since the market correction at the start of the century.

It’s known that past returns are no guide to future performance. However, during the market recovery after the ‘Tech, Media and Telecom’ bubble, better performance came from small and medium sized US companies than from larger businesses. While there is no doubt that some of these technology names are highly regarded companies, whether they justify the valuations that they trade at is another question, putting pressure on the future growth potential of their share prices.

Interest rate cuts may benefit SMID Cap stock performance

The US recently announced a 0.5% cut in interest rates. There is concern that the strong growth that the US has produced over many years is slowing, and so cutting interest rates is the way in which the Federal Reserve, the US Central Bank, aims to prevent an economic slowdown. A lower interest rate means, all other things being equal, more money for companies to invest or return to investors in the form of dividends or share buybacks.

Active management for SMID Cap investing

A growing theme within US SMIDs is the increasing proportion of unprofitable companies within the major indexes. This has been the case for a number of years, as some companies seek to grow their market shares at the expense of profits.

We believe this means it is more important than ever to have an active approach to investing in this area. By that we mean investors could benefit from selecting a fund that is actively run by a fund manager whose job it is to find innovative companies that are starting their journey, with the most potential for success and share price growth.

The alternative to choosing an active fund is buying a US tracker fund which contains all of the companies in a given index , you can see ones that we cover on our Tracker Funds list.

By avoiding the most obviously ‘bad’ companies, however, active investors can focus on trying to invest in companies that offer the potential to grow their earnings and share price over the longer term – and try to achieve better returns than the market.

Worth considering for a long-term investor’s portfolio

No investment is ever risk free, and US SMIDs are no different. Choosing a US SMID Cap fund, such as the GlobalAccess US Small and Mid Cap Fund represents an opportunity to increase a portfolio’s exposure to the US economy, whilst diversifying away from the small number of stocks that have dominated markets since late 2022.

Within a globally diversified portfolio, and with a long-term investment horizon required to tolerate the inevitable volatility that comes with investing in smaller companies, an allocation to this overlooked part of the equity market is worth consideration.