Four reasons to look to US small and mid-cap companies
Four reasons to look to US small and mid-cap companies
The US economy is proving to be more resilient than those of other countries, partly due to its self-reliance on oil and gas. True, there are other inflationary pressures outside of energy which will be difficult to absorb, and interest rates are rising faster than in other regions. This may result in a downturn, or indeed recession – but the economy is still more stable than other developed countries.
This stability gives US equities appeal in an increasingly uncertain world. They may trade at a valuation premium to other regions, and Europe in particular, but the high rating mostly derives from a narrow group of the largest S&P 500 constituents.
The appeal of small and mid caps
The more domestically-focused US small and mid caps, however, are not excessively valued. They offer diversified exposure to the broad economy. Many of these companies don’t have to look overseas for growth, and so are to a degree insulated from the rising geopolitical tensions which look set to reshape global alliances, trade and investment flows.
In fact, a number of these companies could be direct beneficiaries of a more regionalised world economy as US authorities are incentivising manufacturers to “reshore” operations. A series of recent legislative changes is driving a new wave of investment which dwarfs comparative initiatives in other countries.
And let’s not forget, given the size of the US economy, even “small” US-focused companies are large by international standards. This is important at a time when investors are rediscovering risk, as liquidity tightens due to rising interest rates, triggering a range of stresses.
With market valuations ranging up to $20 billion, however, US small and mid caps are a well traded and liquid asset class. They’re also one which offers investors many more opportunities to add value compared to US large caps. This is the result of an amazing drop off in “sell-side” analyst coverage for companies falling outside of the S&P 500.
Sell-side coverage is the research published by investment banks tasked with selling companies to potential buyers. It’s not uncommon for a $1 billion US small and mid caps to have only a few sell-side analysts covering it, and the resulting lack of information plays to the benefit of experienced and well-resourced stock-pickers.
Meanwhile, this could be an interesting point to invest in US small and mid caps, whose valuations are already pricing in a 25-40% decline in earnings. Such a decline would match that seen during the recessionary period which followed the Global Financial Crisis (GFC) – so that’s a lot a bad news.
Additionally, these more economically sensitive, or “cyclical” areas of the market tend to recover well in advance of the “recovery” stage of the business cycle actually being confirmed, reminding us that markets are not economies.
These areas perform differently and at different stages of the cycle compared to the technology behemoths, say, which are exposed to long-lasting, or secular growth trends being driven by well established disruptive forces.
Reason 1. US equity leadership likely to change in the next business cycle
The large cap areas of the market performed very well in the last few years during the long phase of low and steady growth, low inflation and low interest rates following the GFC in 2008– and to an extreme degree towards the end of this period. As a result the S&P500 has become more concentrated in growth sectors like IT than at any other time since 2000 (prior to the bursting of the Technology, Media and Telecoms (TMT) bubble). Meanwhile, the US smaller companies universe has remained well diversified. Once again, big tech valuations are being questioned by the market.
After the bursting of the TMT bubble in 2000, US smaller companies performed much better than larger companies for a number of years up to 2007. This could be indicative of future market direction. This outperformance from smaller companies occurred in years when the interest rates on Fed funds and GDP were both rising and falling. This consistent outperformance during a period of different environments occurred because of the depressed starting point of low valuations and supported by strong earnings growth. There are similarities with the situation today.
Reason 2. Small caps may already be outperforming large caps
There could be signs that a new cycle of small cap leadership has already started. US small and mid caps have been outperforming large caps since the end of January 2022. This is unusual in a period of recessionary fears, but partially reflects much cheaper valuations. A lot of bad news is already priced into valuations which are factoring in material hit to earnings (see reason 3, below).
Reason 3. US small and mid caps are already pricing in a lot of bad news
Based on a comparison of their forward price/earnings ratios, the valuation of US small and mid caps is at almost historic lows versus large caps, despite offering the prospect of superior earnings growth. Earnings growth has been higher than for large caps repeatedly in recent years – without recognition.
Looking forward, however, to a cycle of less liquidity and more volatility, stable earnings growth will more likely be rewarded, so investors do need to be highly selective in the small caps they choose.
For example due to the risks ahead, this is not a time to be buying companies just because their share prices have fallen a long way: the cheapest companies can turn out to be the most costly portfolio decisions.
Reason 4. US small and mid caps to benefit from new US domestic policy focus
Finally, a positive aspect of the next economic cycle will be initiatives to reshore manufacturing and supply chains to the US and neighbouring countries. A domestic capital expenditure cycle has already started which is likely to benefit the more domestically-exposed small and mid cap universe over large cap. This will be supported by a number of fiscal initiatives passed at a Federal level to aide domestic manufacturing. The money involved dwarfs initiatives in other countries, and is likely to catalyse a new wave of innovation especially in energy transition.
Retaining exposure to US equities remains an important allocation in a diversified investment portfolio but there are reasons to reconsider how investors are investing. In the past five years only investing in the S&P500 would have been the best decision but change is underway. There are now good reasons to broaden investments into mid and smaller US companies that are more attractively valued for a changing market environment.
Market leadership is changing and there are some similarities with the period following the bursting of the TMT bubble in 2000. The period 2000 to 2007 was a strong period for investing in US mid and small companies, as well as active management in general.