Money: Buying a piece of America

Nic Cicutti on US stocks with potential

The dream of every investor is to come in to a buying opportunity when the market is at its lowest, with the aim of riding it until it reaches its peak, before selling out. One area where a correction is regularly predicted is the US stock market. There the seemingly never-ending upward movement in US share prices has continued since late 1994.

Alone among the non-movers have been smaller companies, small caps, which have tended to trail their larger brethren, large caps, for the past few years. Yet according to one investment manager, Frank Wisnecki of the US Smaller Companies investment trust, a fund managed by Wellington Management Company, all this is about to change.

Mr Wisnecki points to the performance of the Russell 2,000 small company benchmark over May, which ran ahead of the S&P 500 (larger companies) index for the first time since last December, as our table shows.

"As a result, current valuations for US smaller companies, relative to large cap stocks, are at their most attractive level in several years," Mr Wisnecki says.

"Those investors who purchase select small cap stocks stand to reap substantial gains."

He suggests investors should be prepared to go overweight in small cap stocks within their overall US equity portfolio. In other words, here is the dream scenario. How does Mr Wisnecki justify his stance?

First, he argues, larger company share performance has benefited from fears of interest rate rises by the Federal Reserve. Larger stocks gain because they are seen as more liquid.

Second, mutual funds in the US (the equivalent of our unit trusts) are forced into buying large cap stocks, particularly "tracker" funds. Despite their more attractive price-earnings ratios, small cap stocks have remained out of favour. To this, he adds the large numbers of flotations, which have tended to depress the market in that sector.

He feels such pessimism is unjustified, arguing that small cap stock prices are cheap and their potential now outweighs their risk. Furthermore, capital gains tax cuts in the US will boost this sector, since their returns are mainly capital-gains related. At the same time, low inflation should dampen long-term expectations of interest rate rises.

Mr Wisnecki adds one caveat: "If the run to liquidity and large cap funds were to continue and if the market perceives that over the long term interest rates will climb, small cap performance will face further challenges."

If you believe this argument, now is the time to punt the US Smaller Companies Investment Trust, run by Wellington Management. Unfortunately, not all expert opinion sees things quite the same way.

Michael Mullaney, head of North American equities at Threadneedle Investment Management, the company which manages funds on behalf of Allied Dunbar and Eagle Star, takes a far more dispassionate view of the market, although he agrees with the analysis of the economic fundamentals.

He says: "There are three primary forces that have been driving the US equity market in the past two and a half years. One has been steady economic growth without inflation. The second has been steady operating earnings growth in the S&P 500. The other thing has been the volume of money going into mutual funds at very strong levels."

Although some analysts argue that earnings at this level are no longer sustainable, Threadneedle believes low inflation and steady, but not excessive, economic growth means that risks previously considered excessive must be revalued.

What does mark out the US market is its volatility. In the past few months, shares have undergone a 10 per cent contraction, only to rise by 20 per cent immediately thereafter.

"Unless the Fed starts raising rates, the market will remain ahead. But we are in a choppy situation. The issue is how long can it [existing growth] continue. The honest answer is that we don't know. We are certainly more watchful than we have been," Mr Mullaney says.

But what of the small cap market? Mr Mullaney is unconvinced by those who sing its merits: "We have tended to be underweight. There are some great values in the small cap universe. But equally, in the past few years there have been more and more companies coming to the market, 4,000 since 1990. The quality is less than it was five years ago."

Part of the reason has been that in a rising market, the tendency has been for companies to float quickly.

Mr Mullaney continues to favour large and mid cap companies which, even in the case of the S&P 500, already do not pay dividends, thereby making them too potential gainers from any softening of capital gains tax legislation.

Martin Brooke, manager of the M&G American Smaller Companies fund, argues: "We think investors should be in America. It is ridiculous that some UK pension funds have a negligible amount of exposure to North America.

"If you are investing in America, you have to include smaller companies because there are some good opportunities there which you should not miss out on."

But he warns that smaller companies have tended to underperform and the large volume of new mutual fund money being invested has led to the spectacular growth in the number of new companies coming to the market.

So what should investors do? Before falling for promises by any fund manager, remember that experts' views may be conditioned by the need to attract money to that fund. It pays always to research the opinions of several experts before committing your cash. If there is anything worse than missing the boat when it sets sail, it is getting into the boat only to find it sinking before it leaves the harbour.