By Henrietta Walker, head of the investment specialist team at Brooks Macdonald
Over 2023, global equity markets were dominated by the astonishing performance of the magnificent seven. Led by Nvidia, this group of companies are deemed to be the primary beneficiaries of advances in artificial intelligence (AI).
Lured by the hope of substantial earnings growth, investors piled into these stocks. The strong performance of their share prices has led some stock market watchers to suggest that these companies now look a little pricey.
Their rapid growth has also led to a concentration in the US equity market, with the top ten stocks in the S&P 500 now accounting for almost one-third of the entire index by market capitalisation.
While it is likely that many of these firms will continue to benefit from secular growth drivers such as AI, there is an unloved and overlooked segment of the US equity market that has begun to appear attractively valued – small and mid-cap companies.
Historically, these companies have tended to outperform their larger counterparts for a number of reasons for this.
Their relatively smaller size often allows them to be more agile and achieve higher growth rates. Consequently, they have traditionally traded at a premium, as reflected in their price to earnings ratio versus large and mega-capitalised stocks.
However, a reversal has emerged over the past three years – these companies have been trading at a discount relative to large and mega caps, which is something not seen since the year 2000.
Does this trend mean that these stocks are now a buying opportunity? In the wake of the pandemic, there has been an uptick in deglobalisation, with governments of major economies looking for ways to reduce their interdependence.
This is partly a reaction to disruptions in supply chains we saw during the pandemic, but also due in some cases to rising nationalist sentiment. This has resulted in growing economic protectionism through things like tariffs and various onshoring policies.
Given their domestic focus, small and mid-cap companies could be the primary beneficiaries of this new era.
What’s more, US economic growth remains robust, especially when compared to the likes of Germany or the UK. The US consumer continues to look in good shape, benefiting from tight job markets and above-historic average wage growth.
Another potential tailwind for these stocks is an environment of failing interest rates. Small and mid-cap companies are generally more sensitive to interest rates as they tend to have weaker balance sheets, higher borrowing and have less fixed rate debt and more floating rate debt.
This means they will tend to underperform during periods of rising interest rates, such as the last two years. As we now likely entering a phase of easing monetary conditions this could provide a more favourable backdrop for their growth
The key to seizing this opportunity will be quality and diversification. Compared to large caps, a significantly larger percentage of small and mid-cap stocks are not profitable and could be considered riskier investments.
To mitigate this risk, investors should focus on companies that are profitable and have positive free cash flow. By owning an actively managed fund that is well diversified by industry and stock, risk can be reduced.
Compared to large caps stocks, small and mid-caps are not covered as widely by research analysts. This means there is more opportunity for active managers to find well run companies with strong fundamentals that are currently priced relatively attractively.
While we have seen some of the largest US companies performing strongly over the last year, it now appears that in terms of historic valuations, small and mid-cap stocks are indeed back.
By investing through an actively managed, well diversified fund with a quality-focused investment process, investors can access a part of the US equity market which currently looks somewhat unloved.
This is further boosted by US small and mid-cap companies’ domestic focus, meaning they are best placed to benefit from the robust US economy and rising deglobalisation.
