Small-to-mid-capitalization stocks or large cap stocks? Either or? Or a mix of both?
The evidence is clear that small-to-mid-cap stocks outperform over the long-term and will likely “dwarf” the returns of other asset classes for years to come, according to a report from J.P. Morgan.
Eduardo Lecubarri, European Small & Mid-Cap Strategist, and Global Head of Small/Mid-Cap Equity Strategy, lists the reasons why and breaks down the myths about these kinds of stocks.
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For over two decades, J.P. Morgan has kept a constant focus on Small-to-Mid-Cap stocks (SMid), because of our belief that this asset class would play an increasing important role for asset managers and investors around the world.
We remain convinced that SMid-Caps will dwarf the returns of most other asset classes for decades to come.
So, if you are reading this report, congratulations, we believe you are focusing on the right asset class.
But you are not alone.
The number of dedicated SMid funds in the world keeps growing, with SMid funds as percentage of all actively managed funds also on the rise, and with Large- and All-Cap funds investing a rising share of their assets under management (AUM) in SMid-Caps too.
Below is a summary of our key findings:
- Empirical evidence continues to show that SMid offers superior returns that add up to a sizeable difference over time: following the recent outperformance of SMid, its excess yearly return vs Large-Caps since inception has jumped to 360 basis points (bps) in the Eurozone for example, where the MSCI EMU Small has tripled the performance of the MSCI EMU Large Cap index since inception (1997).
- We believe the excess returns of SMid are due to a list of drivers that are still in place today:
1) Faster growth given that they are smaller companies, often at an earlier stage of development.
2) M&A which is a constant tail wind (>90% of all deals involve a SMid-Cap being bought).
3) Larger insider ownership.
4) Thinner coverage which translates into more inefficient pricing.
5) And their higher concentration of big upside opportunities (investors are 2x more likely to pick a >50% gainer in SMid than in Large).
- All this continues to help SMid portfolio managers (PMs) deliver metrics superior to those of their Large-Cap peers regardless of the size of the fund.
- SMid-Caps continue to command a rising share of the wallet: The number of dedicated funds keeps rising (now sitting at 3,421), with Large-Cap and All-Cap funds having >20% of their AUM invested in SMid-Caps too.
And the future looks even brighter for SMid-Caps in our view:
1) They are less exposed to protectionism than Large-Caps are due to their higher domestic exposure.
2) They are less exposed to regulation from populistic governments as they account for the bulk of the workforce while making up only 17% of the world’s total market cap.
3) And all while continuing to be the solution for some of the problems plaguing the asset management industry (i.e. they are less exposed to passive, more fundamentally driven, and thus more suited for higher-fee active management structures).
- The opportunity appears greater outside the US and within emerging markets in particular. Note that 70% of all AUM invested in actively managed SMid funds is invested in US SMid-Caps when they only represent 23% of the global SMid market capitalization.
Breaking Down the Myths:
1) SMid-Caps are generally less volatile than Large-Caps during upcycles and underperforming by a very small margin in recession-linked downturns with their lower exposure to passive flows also helping on this front.
2) They offer ample liquidity (our analysis shows AUM in dedicated SMid funds could still triple from here).
3) The asset allocation needle needs to keep moving towards SMid as they only account for 30% of all institutional AUM.
4) SMid returns not only don’t suffer but actually improve when in a low growth environment.
5) Sell-side coverage is not declining within developed market Small Caps but it is within Large-Caps.
Don’t look for a better entry point… buy SMid NOW.
1) SMid does best when interest rates are on the rise and we believe they may have bottomed,
2) Valuations are still below those of Large-Caps.
3) With 1 in every 5 SMid-Caps trading below replacement value.
One key risk: balance sheets. Stay away from too much leverage. This shouldn’t be a problem as 46% of all SMid-Caps in the world are sitting on net cash.
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