The war in Ukraine is continuing to have devastating consequences for the people there, and nobody knows when a resolution can be found, though we all hope it is soon.
Such circumstances bring a great degree of uncertainty for investors, and it may persist for some time.
We believe investors may wish to seek opportunities that are not only partially shielded from that uncertainty, but also positioned to capture potential upside should a resolution cause a global, risk-on rally.
Meanwhile, interest rates are likely to remain low relative to history even if the Federal Reserve (Fed) continues to raise rates from the bottom. For investors seeking higher returns, we believe that listed equities remain the most attractive liquid asset class.
The strength of the US economy persists and we believe domestically-focused companies are insulated from the tragic war in Ukraine. They could be well positioned to deliver strong performance for investors.
Not only are US small caps more domestically focused, but they also currently offer cheaper valuations as further protection.
Equity indices and price movement since Russia invaded Ukraine
Europe has significantly underperformed since the invasion, followed by emerging markets and Japan. US stocks have held up, but US small caps (as represented by the Russell 2000 index) are outperforming the globally exposed S&P 500 and NASDAQ. See Figure 1 below.
Why are small caps beating large caps?
1. Composition of indices
The composition of the S&P 500 has changed considerably in just a few years following the increasing weight of the well-known technology stocks. This has changed the characteristics of the benchmark from a diversified economic exposure to a concentrated secular growth factor with higher overseas risk.
Meanwhile US small caps, as represented below by the Russell 2000 index, remain well diversified, with a strong domestic bias.
2. Domestic exposure
The vast majority of small caps’ revenue exposure is domestic, potentially offering these equities a hefty buffer against what ensues abroad.
3. Valuations
US small caps are currently trading at a price-earnings discount relative to US large caps.
4. Earnings outlook
And yet earnings per share are forecast to grow more for US small caps than US large caps in the coming year.
Looking ahead
No one knows how long the war in Ukraine will last, but we can try to minimise its impact on investor portfolios while also gaining exposure to longer term, structural macro tailwinds.
US small cap stocks tend to source their revenues domestically, insulating them somewhat from global geopolitical disruptions. The small cap universe offers a wide variety of companies that may benefit from the strong domestic economic growth we are experiencing. Cheaper valuations and faster earnings growth offer a better entry point relative to US large caps.
These macro tailwinds, combined with our US small cap team’s process of selecting companies with diversified performance drivers, offer investors an attractive strategy for achieving capital growth.
