Focus on US – Legg Mason sees growth potential in US small caps

Legg Mason says American small cap stocks have had a “convincing comeback” since the financial crisis.

At the end of October the Russell 2000 index was at its all-time high point with a value of 818.73, which offset the losses caused by fears about the breakup of the Eurozone and a double dip recession.

And the asset class still has room for positive improvement, the firm believes. Valuations of the stocks in the Russell 2000 index are still below their long-term average values, even despite the index being at such a high point.

Klaus Dahmann, head of sales for Germany and Austria, contrasts this with the situation in April last year, when the valuations were above their historical levels.

But he says that “paradoxically, investors have been more interested in emerging market equities in the last 12 months, although valuations have been worse there than in the US.”

But US small caps also offer attractive growth potential similar to emerging markets, Legg Mason says. The average annualised performance of the Russell 2000 over the last three decades has been 10.34%, according to Bloomberg.

Dahmann points out that 42% of the stocks in Russell 2000, with the exception of financials, have net profit margins below their average values. This means there is potential for growth in the asset class, he says.

“At a time when the weak economic situation makes it difficult to find equity markets with growth potential, the asset class looks attractive,” he concludes.

Small cap stocks tend to be more volatile than large caps, however, which makes it difficult for active managers to outperform the index.

Legg Mason’s US Smaller Companies Fund, for example, has underperformed the index year to date. It is only up 2%, while Russell 2000 has gained nearly 10% since the start of the year.

US small cap ETFs, on the other hand, such as Vanguard’s Small Cap Index Fund and its Russell 2000 ETF, Schwab US Small Cap ETF, iShares Core S&P Small Cap ETF and various others, have displayed performance that is at least as good as the index, and often beats it.

This places a question mark over the advantages of accessing the asset class though an active fund, when ETFs offer better returns and lower investment fees.

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