US small caps are set for a period of outperformance when interest rates start to rise according to Mark Sherlock, lead portfolio manager of the Hermes US SMID Equity fund.
Sherlock says that history shows that small caps returned 13 per cent per year during the US rate hikes from 1963 through 2012, compared with an 8.1 per cent yearly return from large caps.
Meanwhile with US economic growth forecast to rise from 2 per cent in 2014 to 3 per cent in 2015, Sherlock says the small and mid cap stocks will benefit more than the large caps.
“This is because typically 80 per cent of the revenues generated by smaller companies are exposed to the domestic recovery, compared with 54 per cent for large caps,” he says.
“The cycle is turning in favour of high quality companies, which are trading at a discount to the market and provide earnings growth that we expect to generate strong returns.
“As the US equity bull market matures, high quality smaller companies are attractively valued and provide exposure to accelerating domestic economic growth.”
Over the past five years to the end of July high quality companies have underperformed the lower quality companies considerably, returning 109.7 per cent compared with 203.8 per cent.
However Sherlock says the Federal Reserve mentioning tapering for the first time in the second quarter of last year “marked a turning point”. He says that since that point the one-year returns of high quality stocks have kept pace with their lower quality peers.
“From here on, as investors prepare for tighter monetary policy, we expect volatility to rise and market returns to be more modest,” he says. “In such environments, high-quality companies with durable competitive advantages typically outperform because their dominant market positions lead to pricing power.”