Four reasons for investing in US small and mid caps (and four challenges)

In the US, small cap stocks are generally regarded as those with market capitalisation below $3 billion dollars, while mid cap stocks can be as large as $15 billion.

Relative to other markets around the world, these numbers may seem enormous. In fact, small and mid cap stocks represent less than 15% of the total market capitalisation in the US stock market. As a point of reference, US large caps are generally defined as companies with a capitalisation above $35 billion. 

While market movements may cause the defining market cap range to vary over time, the characteristics that make this part of market appealing for active management remain consistent. 

1. Under-the-radar opportunities

US small and mid caps can be a richly rewarding space in which to invest. It offers investors the opportunity to discover misunderstood or poorly-known companies, while still providing sufficient trading liquidity to help mitigate risk.

While the large cap space is highly efficient in information dissemination and absorption, this is not the case as one moves down the capitalisation scale. This is due to lower levels of analyst coverage. The average small and mid cap stock has fewer than six analysts writing about it and one-third of these companies have fewer than two analysts covering them. The story is quite different for their larger cap brethren, where the average stock in the S&P500 has 21 analysts covering it.

In an increasingly digital world where identifying information inefficiency is more challenging, the small and mid cap space remains fertile ground. Perhaps this is one of the reasons that 49% of active managers in US small and mid cap have outperformed their benchmark over the last ten years versus only 39% in large caps.

2. Small and nimble

The dynamism of small and mid cap companies remains the hallmark of the asset class. Smaller companies have the ability to adapt their business models and invest in new lines of businesses that can have meaningful impacts on their enterprise in a short periods of time.

Changing course for a yacht is a lot easier than for a container ship, as recent events in the Suez canal have demonstrated.

3. Complement to a large cap holding

Over longer time periods, US small caps have generally outperformed large caps, but nothing occurs in a straight line. Small and mid cap stocks tend to outperform during economic recoveries, while large caps tend to outperform during periods of economic uncertainty.

After over a decade of economic growth that failed to achieve “escape velocity”, the paradigm is finally shifting. The more domestically focused small and mid cap universe is poised to benefit disproportionately as the domestic US economy experiences the strongest growth in a generation.

We see a sustainable tailwind to this US recovery, fueled by unprecedented fiscal and monetary stimulus working in unison, capital expenditure to secure supply chains (“on-shoring”), healthy corporate balance sheets, and an unsustainably high consumer savings rate.

Timing inflection points in economic cycles is always challenging. Eventually as this cycles matures, large caps will begin to outperform small caps as the market begins to discount a slowdown. Given that large and small caps tend to have different periods of outperformance, we believe it is best to adopt a long-term strategy which includes both large and small cap allocations. 

4. Greater possibility of above-benchmark returns

Another interesting difference between the mid and large cap indices is a greater opportunity for finding alpha (returns that are superior to the benchmark) in mid caps. Sector correlations with the benchmark are noticeably lower in mid cap versus large cap. As an example, the financial stocks in the large cap universe have a 0.70 five-year correlation with the S&P 500 (+1.0 being a perfect correlation). However, in the small and mid cap Russell 2500 that correlation drops by 21 points to 0.49.  

Contributing to this difference in correlation is that in large cap the top 25 companies comprise 40% of the index; for mid cap that number is 7%. Across every sector there is a lower correlation of the underlying stocks within the sector in the mid cap space relative to large. This lower correlation provides greater opportunity for alpha through stock selection for active managers.

There are of course difficulties and challenges in the small and midcap space. Here are four:

  • Smaller companies are riskier businesses than large cap stocks because they tend to be less diversified business models and have more limited access to capital to manage through difficult periods.
  • Small cap stocks are more volatile than large caps as measured by risk measures such as beta and standard deviation.
  • They are more time consuming to research. There is less readily available information on them (a byproduct of lower sell side coverage). 
  • Trading can be more difficult as at lower levels of liquidity it can take longer to sell (or accumulate) positions.

Why now for US small and midcaps?

The economic cycle and market factors have changed dramatically over the past year, favouring both the investment universe of small and mid cap stocks, as well as a fundamental stock selection approach to the asset class.

The US economy is on a path to the strongest calendar year of GDP growth since 1965 if analyst projections remain accurate. Earnings growth is easier to find now than it has been for some time. We have transitioned from “Growth at Any Price” to “Growth at a Reasonable Price”.  After over a decade of growth being scarce and market participants paying any price, growth is now everywhere and it is valuation that is scarce.

As a result, growth-oriented managers in the US who dramatically outperformed in 2020 are now lagging, with value and core managers outperforming. 

There is an important difference between the composition of the large cap and the small and mid cap investment universes. Cyclical sectors make up more than half of small and mid, whereas technology, internet, media and telecom – traditional growth sectors – account for less than 20%.  This is not the case for large cap where the S&P 500 has 30% in technology stocks, not including Amazon and Facebook. 

With an economic recovery underway, the more domestic and cyclical small and mid cap market could be poised to outperform. The economic recovery and commensurate change in market leadership is an inflection point for small and mid caps that can last.

Last year was difficult, but we believe now is an opportunity to swim with the tide.