Time for Smaller Stocks to Shine?

Small- and mid-cap (SMID-cap) stocks have long attracted investors’ attention—mainly due to their tendency to outperform their large-cap peers in the long run. Yet more recently, they have significantly lagged the broad market, causing frustration among investors. While historical performance has always been episodic, the S&P 500 index has returned 227% over the past decade, including dividends, while the SMID-cap Russell 2000 has only generated 109% (Display 1).

That’s left some investors wondering whether large-caps are the only game in town. Have the benefits of SMID-cap stocks, like total return and diversification, vanished forever…or are they poised to spring back to life? The recent sharp rally in smaller company shares in July 2024 has brought this question into even greater focus.

What’s in This Meal?

Just as different ingredients will change the taste of a dish, the composition of an index can greatly affect its performance. This is especially true for small-, mid-, and large-cap indices.

When most people think of the broad market, they think of the S&P 500 index, which is made up of large-cap stocks. Yet, due to the dominance of Big Tech/Magnificent Seven companies, the S&P 500 is heavily skewed toward technology and communications. In fact, over 30% of the index falls into the technology sector, with another 9% in communications (largely Google and Meta). In contrast, the S&P 600 and 400 (representing small- and mid-cap stocks, respectively²) have much lower exposure to these sectors, with technology making up around 10% and communications around 3% (Display 2).

What about SMID-cap companies? They tend to have a different composition, with a greater emphasis on industrials and financials, and a slight skew toward real estate and materials. This tends to make SMID-cap indexes much more cyclical and sensitive to interest rates and inflation compared to their large-cap peers.

While the outsized financials exposure among SMID-cap stocks may benefit from higher rates (offsetting some of the headwinds faced by other cyclical sectors), we believe these sector tilts explain much of the persistent gap between SMID-caps and large-caps since the pandemic. For instance, compare the PMI manufacturing index relative to its services peer. Manufacturing around the world has been in a downturn for two years, coinciding with the post-pandemic interest rate hiking cycle. Meanwhile, services have held up better. This makes perfect economic sense, given the disparate sensitivities of those sectors to interest rates.

Even more surprising? What we see in each index’s aggregate financials. Consider that over several different time horizons,¹ mid-cap stocks’ sales growth has actually surpassed large-caps. Meanwhile, small-cap stocks’ sales growth has lagged in recent years. But once you factor in costs, the picture grows murkier, mainly because small-cap earnings fluctuate so dramatically (you can reach conflicting conclusions depending on your starting and end points). What does stand out is that metrics like sales, operating earnings, and EPS are much more volatile for SMID-cap stocks than for large-caps—mainly due to their more cyclical nature, in our view.

Additionally, many leading large-cap companies hold substantial cash positions, which tend to dwarf their debt loads. That puts the index-wide net debt/EBITDA ratio at a quite conservative 1.4x. By comparison, mid-caps are levered 3.0x and small-cap stocks at 4.0x versus 2024 consensus EBITDA.

Finally, many more SMID-cap companies are unprofitable. Roughly 40% of Russell 2000 index constituents lost money in 2023. And while overall EPS before extraordinary items came in at $28, that figure surges to $127 once companies with losses are stripped out. Doing the same for the S&P 500 would only raise EPS from $190 to $203.

The Long View

Over longer periods, research has shown that SMID-cap stocks tend to perform better and offer higher returns than what their volatility levels would suggest. This phenomenon, known as the “size premium,” was first identified in 1992 by finance professors Eugene Fama and Kenneth French. Yet, more recent research suggests that this trend may no longer hold true. While this doesn’t necessarily mean that SMID-cap stocks will perform poorly, it does suggest that they may deliver returns similar to those of large-caps.

But even if the long-term returns for small-cap stocks and large-caps converge from here, there’s a case to be made for leaning into small-caps when it comes to active management. Academic literature, market data—and our own investors’ experience—have demonstrated that there is greater potential to outperform the market and generate “alpha” in SMID-cap stocks over time compared to large-caps. If you uncover a stock universe where active managers can enhance total returns, it makes sense to overweight that group.

In addition, as SMID-cap stocks have lagged, their relative valuation versus large-caps has hovered near all-time lows for almost three years. Some discount seems justified due to the fundamental differences we’ve discussed, but should it really be this steep? While valuation alone is not an investment thesis, it does appear that SMID-cap stocks are more likely to be undervalued than overvalued at this juncture.

Is This Finally the Moment for SMID-Cap Stocks?

Simply put, we have very little conviction when it comes to which size of stocks will outperform over the coming years. There’s a fairly strong case that the looming interest rate cuts should benefit manufacturing and cyclicals, helping SMID-cap stocks. But the economic cycle is in the late expansion stage and there’s a low (but still higher-than-usual) chance of a recession in the coming year or two. Taken together, these could easily offset any boost from interest rate cuts.

On the other hand, large-caps continue to exhibit strong growth, greater stability, and higher exposure to the most prominent secular tailwind—artificial intelligence. Much of that, perhaps too much, may already be priced in. As a result, we have little faith in making a definitive call. With that said, we do retain a slight bias toward small-cap stocks due to their relative attractiveness as a less efficient universe for stock pickers.

In our industry, it’s generally inadvisable to make all-or-nothing allocation decisions. The future is unpredictable and there are many potential outcomes, some of which may favor SMID-cap stocks while others may favor large-caps. Without a crystal ball, the best approach is to maintain a balance of both. Our ultimate goal is to help our clients achieve their financial objectives without taking on excessive risk, regardless of which group outperforms. As a result, diversification remains one of our most important guiding principles.