T. Rowe’s US small-cap analyst on “less attractive” valuations in the US market


Eric Papesh, US equity portfolio specialist on the $908m T. Rowe Price US Smaller Companies Equity fund, tells Fund Strategy why it’s “difficult to call” whether US small and mid caps will outperform their European and Asian counterparts in the near term and why the fund holds a whopping 200 names.

Will domestic stocks perform better than international firms after the Trump vote?

The US Smaller Companies portfolio will always focus on the US small-cap and mid-cap market. While we’ve got a handful of companies with Canadian operations, mostly within the energy and commodity markets, the bulk of our work targets US domiciled companies.

From a bottom up standpoint, there are always interesting opportunities to take advantage of.  We’re always trying to identify controversial, out-of-favour companies which are fixing problems and turning themselves around. Similarly, we’re also constantly trying to uncover successful, rapidly growing companies where the market hasn’t fully appreciated the long-term potential.

Within T. Rowe Price, our asset allocation team is seeing slightly more value currently in non-US markets at the moment. From a valuation standpoint, the US market is less attractive compared to Europe and Asia, and is further along in its economic expansion. Offsetting this, however, is the fact that geopolitical anxiety feels somewhat elevated at the moment, and US markets tend to be viewed as a relative safe haven compared to other regions around the world. It’s a difficult call.

Would you consider increasing exposure to US banks or energy firms?

We’ve already got a decent amount of exposure to small cap and mid cap banks. Credit trends within the US remain generally positive, and we’re anticipating higher levels of M&A activity going forward. Post-election, we’ve seen rates move sharply higher over the past week or so, which will obviously be positive for banks and insurance companies as well.

In regards to energy, we remain cautious on the prospects going forward. Technology and productivity enhancements have had a tremendous impact on the space. Our base case at this point is that markets will remain oversupplied for the next year or so. In the portfolio, we’ve focused on identifying those companies we believe are best positioned to withstand a difficult environment. Our companies generally have better balance sheets, good acreage, low-cost assets, and will be able to deliver production growth at relatively low oil prices. We expect many of the higher-cost producers will likely continue to face challenges going forward.

Will you be making any changes to the portfolio in the near term?

We’re not making any dramatic changes to the portfolio in response to the outcome of the US presidential election. Going into the election, our expectation was that regardless of who won, the vote was going to be close either way. There was going to be a big segment of the population that was unhappy with the outcome. At the margin, we’ve brought the cyclicality of the portfolio down a bit over the past few months.

Going forward, we expect to see generally higher levels of volatility within the market. We’ll continue to take advantage of that volatility, and try to identify stock-specific opportunities across the market where we think they are mispriced relative to their longer-term economics.

Longer-term, there are many questions that remain unanswered. What will be the impact of changes made to trade and immigration policies under the new administration? How will changes in taxes and in inflation play out across the broader economy? It’s hard to envision a great deal of certainty on many key issues in the near term.

The fund has a large number of holdings (200), how do you think this is an advantage for the fund?

In our view, there are many advantages to running a broadly diversified portfolio when properly supported. Since the firm was founded, we’ve been big believers in the value of fundamental proprietary research.

The goal of our US Smaller Companies fund is to leverage the insights of the full investment team. We want to build a portfolio that has a chance at winning in a variety of different market environments, rather than one that can only do well in a certain type of market. We attempt to find attractive investment opportunities across the full range of the small-cap and mid-cap market. We’ve historically held roughly 200 or more individual names in the portfolio, with broad exposure to all sectors of the market.

Investing in biotech companies provides a great example. Many investors think of biotech names as “binary” investments – they either succeed dramatically or fail dramatically depending on the results of their trials with regulatory agencies. There aren’t many names that simply track the market over time.

We want to own those names where the odds of success are stacked in our favour, but we recognise that they all aren’t likely to be winners. By owning several names, each at smaller individual position sizes, we benefit from the winners, and the negative impact from those we get wrong doesn’t derail the portfolio’s performance. Similar arguments can be made for investing in other parts of the market as well.

As the firm has invested in this asset class since the 1960s, how has the asset class performed throughout different presidencies historically?

Historically, small cap investments have provided investors with faster growth in both earnings and in revenues, and with better returns. Small cap companies tend to be more closely linked to trends in the US economy than their large cap peers, where many companies derive a significant portion of sales from international markets. Accordingly, rather than which political party has been in office, the performance of small-cap US equities has been more influenced by the underlying trends within the US economy.