A new day for small- and mid-cap stocks?
Small- and mid-cap U.S. stocks have underperformed their large-cap peers for the better part of a decade. Portfolio Managers Jonathan Coleman and Brian Demain argue that the law of averages suggests that pattern could reverse – and could endure for longer than investors might expect.
4 minute watch
- Small- and mid-cap U.S. stocks have underperformed large-cap peers for more than a decade. But over long time periods, small and mid caps have historically outperformed large caps.
- As such, the current market cycle could be due to reverse for an extended period of time.
- In addition, well-managed companies could emerge from a global economic slowdown stronger and give investors the opportunity to participate in compounding growth.
Equity securities are subject to risks including market risk. Returns will fluctuate in response to issuer, political and economic developments.
Smaller capitalization securities may be less stable and more susceptible to adverse developments, and may be more volatile and less liquid than larger capitalization securities.
Carolyn Bigda: In your opinion, why should an investor have exposure to small- and mid-cap stocks in their portfolio?
Jonathan Coleman: Well, for small caps, I think it’s the fact that you really are getting exposure to the innovation engine of the most dynamic, one of the most dynamic economies in the world in the United States. And the companies that are at a small scale and thriving and hopefully becoming much bigger over time.
It’s also, I think, an interesting time to think about small-cap stocks because oftentimes, return profiles go in very long waves or cycles. And we’re coming off of a period of 10 or 12 years in which large-cap stocks have significantly outperformed small caps. If you look over the very long course of history of equity market returns, you would see that small caps have outperformed large caps over time.1 But we’re coming off, again, a long period in which that has not been the case. So, you know, no one has a perfect crystal ball, certainly not me. But odds would argue that in the near future, there will be a period of time in which small caps could exert a better return profile than large caps and if that happens, that could happen for quite an extended period of time.
Brian Demain: Yes, I mean, I guess what I would add to Jonathan’s answer is, you know, we are in the small- and mid-cap universe; we’re able to invest in some very powerful secular themes in kind of ways that aren’t sort of first-order effects, in the way people think about that most obviously. So, we think the electronification of the car is a very powerful secular trend over the next 10 or 15 years as cars move from internal combustion to electric. You know, Tesla is obviously the poster child for that, but that’s a mega cap. And everybody knows what’s happening at Tesla and it has a valuation that reflects some of the understanding of the company that’s out there. We’re able to find semiconductor suppliers, connector companies, these sorts of companies that supply componentry into not just Tesla, but all of the EV [electric vehicle] makers. And these are a little off the beaten path and kind of not in every investors’ radar. And so maybe there’s a little, there’s a greater opportunity for capital appreciation over time as these stories become recognized.
Bigda: So, let me ask you the difficult question, which is, do you think this kind of economic environment could be the catalyst that helps small and mid caps start to outperform again
Coleman: It’s hard to accurately predict what the catalyst is going to be. But I would go back to small- and mid-cap compounding growth businesses being a little less cyclical than their large-cap peers, less exposed to global pressures. And so, I think there’s a reasonable case to be made for the fact that these businesses could show better resiliency in a more difficult economic environment. And that could be a catalyst to their outperforming.
Demain: The investment philosophy that we utilize was really born out of the lessons a lot of us learned kind of watching the dot-com crash. And we saw at that time the, you know, the risks of not being aware of the various risks that go into investing, whether it’s valuation risk or business model risk or management risk or growth risk. And so, you know, as Jonathan said, none of us really know with a crystal ball what the macroeconomic environment is going to look like. But if we are deliberate about addressing these risks, we think we can, you know, find companies that can weather challenging environments and oftentimes emerge stronger on the other side of that.