Lara Castleton: Hello, and thank you for joining this episode of Global Perspectives, a Janus Henderson podcast created to share insights from our investment professionals and the implications that they have for investors. I’m your host for the day, Lara Castleton.

Today, we’re back with Jonathan Coleman and Brian Demain to get an update on the state of small- and mid-cap companies. Investors have been wondering if and when performance of smaller-cap companies will close the gap with their large-cap counterparts, and what fundamental opportunities exist in this environment. So, gentlemen, thank you both for being here.

Jonathan Coleman: Thanks for having us.

Castleton: So, the market environment does seem to have finally been shifting. The Fed has been cutting interest rates twice this year. Inflation is more or less cooled, and the economy on the surface seems to be holding up. So, Brian, if I can go to you first, how have midcaps been doing in this environment?

Brian Demain: Midcaps have underperformed both large and small caps year to date, but they’re not having a bad year. The mid-cap index is up high single digits year to date, and I think what’s been most pronounced is just kind of what’s worked within the mid-cap universe. And what we’ve seen is really the most expensive stocks have driven the majority of the return. We look within the Russell Mid-Cap Growth Index, and if we look at the index on price-to-sales deciles, the most expensive decile of price to sales is up about 70% year to date, and the second most expensive decile is up about 40%. And again, that’s against an index [that is] up high single digits. So, a very narrow and concentrated set of performers.

And then we also look at kind of the factors driving returns, and there we see really risk-on factors being the key drivers of returns. So that could be momentum or beta or valuation, but the companies with higher momentum, higher beta, higher valuation are really kind of driving the market. So it’s been an OK year for midcaps as a whole, but a narrow group of winners have done exceptionally well.

Castleton: So, I just want you to repeat that one more time. Top decile from a valuation perspective up 70% … 70% year to date; that’s quite staggering. OK, very, very diverging performance occurring within the caps, but maybe broadly up year to date as a whole, part of that does come to maybe more of the backdrop with rates coming down slightly. Jonathan, as a portfolio manager on small caps, they are even more rate sensitive. Same question to you, what’s the background then for small caps this year?

Coleman: So, I think you’ll hear many similar themes as Brian described in terms of what we’re seeing in the small-cap market. Thankfully, at least for a small-cap manager myself, we’re seeing small cap outperformed for the first time in quite a few years. Since the Liberation Day lows, the small-cap benchmark, the Russell 2000, has outperformed the S&P 500 by about four percentage points as of the end of October. And so we are seeing, you know, for the first time in a while, small caps do better on a relative basis.

We’re also seeing a big bifurcation in the market. Companies … the stat that I will give you that’s quite dramatic is that the highest-performing companies in the small-cap universe are the cohort of companies without any revenues; they’re up about 65% as of the end of October on a year-to-date basis. And so that’s evidence of extreme pockets of speculation that we see in certain parts of the market.

In contrast, we also see a large group of companies that we think can compound earnings growth at a mid-teens level, selling at around mid-teens PE multiples. And we think those are very attractive kind of long-term valuations to pay for companies that are going to be growing their cash flows.

One last point I would make on the rate environment is that it is true that I think the knee-jerk reaction to lower … rate cuts is that you should run out and buy small caps. We’re thankful for that support of the small-cap market. History would actually tell you that small caps don’t necessarily need zero or very low interest-rate environment to perform well. In fact, the 1970s was the single best period of small cap market performance relative to large caps in history. And we see some similarities between the 1970s and today. We see an immigration policy that’s restraining labor that is somewhat inflationary. We see a tariff policy that is also inflationary. And we see this larger deglobalization trend that, all things being equal, does add upward pressure on inflation and interest rates over time.

Castleton: So, it seems like there’s just broad exuberance from the market in general with equities. Does that cause you guys concerns then as you’re looking at the underpinnings of your indices?

Demain: I mean, I would say it probably causes concern at the index level. I would say, you know, the way Jonathan talked about teens for teens, I think, you know, we see our version of that in the mid-cap universe. I think we think there are lots of companies out there that offer exceptional risk-adjusted returns; it’s just those might not be the companies that are kind of leading the charge in these most speculative areas of the market today.

Coleman: Brian has a slide in his deck that says, “beware the index”. And I do kind of like that because we think it’s really a time for active management, and blindly buying the index when you have a lot of these constituents that have grown to larger percentage weights in aggregate in those indices is a little more perilous now given the pockets of speculation that we see.

Castleton: OK, well, so then let’s talk through those fundamental opportunities that you two as active managers see within your respective universes. If I could boil down kind of the three biggest tailwinds, potentially … maybe not the biggest, but three big ones for smaller mid-cap companies, maybe we’ll both have you answer them as we go through them.

The first would be reshoring, which is a trend we’ve been talking about for quite some time. Brian, let’s start with you. As it pertains to restoring, bringing supply chains back home, have you started to see a pickup in activity within your universe?

Demain: Yeah, I would say we’re definitely seeing it. I mean, obviously, the highest-profile areas of investment have been in data centers and semiconductor fabs. So, you know, those are the ones that we’ve sort of seen in the newspapers, but it’s definitely broader than that. You know, it’s kind of across industries and across supply chains, and that can be supply chain resilience, that can be tariff avoidance. There’s a lot of underpinnings of that.

I would note that if you look at non-residential fixed investment, you know, that number really came screaming out of COVID. That’s been, it’s been sort of flattish since then, but at a very elevated level. So, the investment is ongoing; it’s probably not accelerating from a high level, but we’re definitely seeing it. And I think the way we think about that from an investing backdrop is to really … we talk a lot about the proverbial selling pickaxes to the miners. So, we’re looking at companies in areas like industrial distribution that just sort of benefit from this buildout, kind of no matter the industry or the region within the country where that buildout may be happening, they kind of tend to stand to benefit as long as it’s happening holistically.

Castleton: And this is a long, likely a long-duration trend, but it sounds like you are starting to see some of that happening today.

Demain: I mean, that’s right. I mean, it’s sort of … it took 20 years since China entered the WTO [World Trade Organization] to sort of see the hollowing out of a lot of this manufacturing capacity. Obviously, a lot of that is not coming back here, but a fair enough [amount] of it will that it’ll be a tailwind for a long time.

Castleton: OK. So, small caps, same trend? Are you seeing that pickup in spending today occur?

Coleman: We are. I think it’s a nascent phase, and I think you’re correct to characterize this as a very long-duration trend. And Brian was correct to characterize … you know, we saw 20-plus years of globalization. I think the phase of deglobalization is also going to be measured in, you know, a decade plus. And so capital allocation decisions, even for very small companies, are not made haphazardly or rashly. And there was considerable uncertainty around economic policy, and there’s still some around tariff policy today. And so, I think companies are navigating this, but we are certainly seeing pockets of areas in which companies are really leaning in and deciding to reshore some production.

Castleton: If I could just add on to that, as a theme in general, is it probably true then, de-globalization, domestic companies are … more small-, mid-cap, they tend to be more based at home. Does that also leave them more insulated from potential conflicts abroad or tariff policy? Maybe we should address that as well.

Coleman: Yeah, I think that’s … it is a favorable factor on a relative basis for small and midcaps. I think significant trade tensions are really not good for the global economy broadly. However, small companies tend to have less exposure to international customer bases than their large-cap counterparts do.

Castleton: So, another tailwind that we are seeing is clearly an uptick in deal activity this year. So, if I can go to you, Jonathan, to start, there has been a rise in M&A activity. How are you seeing that affect your small-cap universe?

Coleman: It’s interesting, we’re really seeing the concentration right now is in the biotech space. So large-cap pharmaceutical companies have very cash-generative business models, but they do face patent cliffs. And so, they need to both augment those potential cashflow risks with internal development as well as strategic M&A. And one of the real tremendous benefits of the dynamic U.S. economy is that we have incredibly innovative life sciences research. And so there’s always a cohort of small-cap biotech companies that are bringing to market or having clinical trials for innovative treatments. So, we’re seeing a lot of M&A activity.

There was concern and speculation about the FDA’s new leadership and their approach to approving drugs. I would say our early observations on that is that drug approvals have continued at kind of a similar pace to what we’ve seen in the past. And I think that’s supporting the bid that we’re seeing for many biotech companies. We love to lean into that opportunity at Janus Henderson; we have extreme domain expertise in the space. We have three Ph.Ds. and one MD on the Denver-based research team. And so, we really view that as an area where we have particularly good insight, and we’d like to reflect that.

Castleton: Great. And Brian, does M&A activity affect midcaps at all? Is that something that you’re looking at?

Demain: Yeah, I mean, we … to a lesser extent than small cap, but we do see some of what’s been happening in the biotech space has been a tailwind within the space. I would also kind of point to, look, mid-cap companies can be acquired. They can also be acquirers. And I do think it’s a constructive backdrop for companies that are prudent allocators of capital in an M&A setting. You’ve obviously got a more favorable government regulatory framework that will enable deals to close more easily. And I would add on top of that, a lot of what’s happened in the private markets over the last five or 10 years, a lot of capital’s flowed into those markets, and that capital really wants liquidity. And so that leaves public midcaps as sort of favorably positioned to acquire some of these assets. So, I think the key there is to find the management teams that are going to be prudent stewards of that capital and are able to deploy it constructively, taking advantage of that favorable. backdrop.

Castleton: Very interesting. I was going to ask about private markets. So, it seems like you already commented on that. Companies … the other thing, maybe to Jonathan … companies staying private for longer has been something we continue to hear. Do you have any thoughts on the private universe, especially as it pertains to small caps?

Coleman: I think that’s undoubtedly true. The advent and growth of private capital markets has allowed companies, should they choose, to stay private for longer. I think there are lots of reasons why companies do want to be public. One that’s significant is just that liquidity and the ability to grow with a new set of owners that perhaps is not as directive, in terms of the path of travel that a company should be. When you have an 80% or 100% owner, they control everything. If you have a dispersed group of public-company investors, you have more control as a management team over your destiny in a certain sense.

And so, I think those opportunities will always be intriguing and interesting to small-cap private companies that want to go public. In the second half of this year, we are seeing the IPO markets open up really for the first time in about three years. I’ve been a small-cap investor for over three decades, and this kind of three-year period, that wasn’t the fact that there were zero IPOs, but there were relatively few, so we would kind of call the IPO window being closed. That was the longest time that I can remember the IPO window being closed. And we’re starting to see that open up. So, I think it’s easy to say that private markets are kind of taking over the world, and there’s no role for small-cap public companies anymore. We would take a more optimistic view on the opportunities in small-cap equities.

Demain:

I just want to add something to that. I mean, all else equal, which it never is, of course, a company’s cost of capital should be lower in the public markets than in the private markets because of the liquidity that the public markets offer. There’s a lot of reasons companies have stayed private longer, but one of the things that is definitively changing is the cost of capital in the private markets is going up because people are realizing the importance of that liquidity. And I think sort of secularly that bodes well for companies coming to coming to the public markets maybe a little earlier in their lifecycle than they have over the last five years. Again, it’s not black and white, and that’s not the only factor, but it’s an important change.

Castleton: Very interesting. So, deal activity has clearly picked up and, sounds like, may continue going forward. [We] talked about reshoring. Third has to be AI; we do have to address that. That’s obviously trickling into almost every company and podcast and everything we’re talking about these days.

So, let’s start with you, Brian. Just how do you view, especially within the mid-cap universe, AI, and how is it an investable theme for you?

Demain: Yeah, I mean, obviously it does need to be discussed. I think it’s, you know, accounting for more than half of GDP growth in the U.S. this year, so it’s an incredibly important factor. I think as we go down in market cap, it’s just important to note that the companies that are involved in the AI infrastructure theme down in market cap, it’s a different set of companies we’re looking at than the ones large-cap investors get to have the opportunity to look at. We’re not looking at the hyperscalers, we’re not looking at NVIDIA. These tend to be … we tend to look at suppliers of components within data centers or kind of the more speculative AI data-center build companies. And I would just kind of characterize these all as higher torque to this AI buildout theme, just a much higher beta to the theme as a whole.

Our approach as we look at this is to find the companies that we think have sustainable competitive advantages and that are share gainers within the data center build. And that’s a nuanced way of sort of approaching the theme. We understand what’s going on, and the rationale for the buildout. But within that, and when you look down in cap, there are going to be companies that are fast growers today, but then there’s a new, Chinese competitor that comes in and destroys their unit economics. Or companies that are fast growers today, but then some white-label supplier is able to disrupt them. And so, we’re really trying to be very deliberate about the competitive advantages of the companies in which we invest.

Castleton: Jonathan, what about in the small-cap universe?

Coleman: Yeah, I strongly agree with all that Brian laid out, and we’re seeing strong similarities in the small-cap part of the universe. What I would add to what Brian said is what we’re starting to see, which is intriguing to us, is what I would call a second-order beneficiary of AI.

So, I think Brian Aptly described the first order, which is the buildout phase. And there are many companies that are benefiting from that, some which will be quite sustainable and others that have questionable competitive positions long term. The second-order beneficiaries are the companies that are utilizing AI to make their businesses more efficient, and we’re starting to see some use cases. I know Brian is as well, in mid-cap. We’re starting to see the use cases in small-cap companies that are making these investments in enhancing the productivity, expanding operating margins for their companies. These are still kind of nascent use cases, but we’re starting to see the proliferation of those. And ultimately, we think that is very exciting, both for small- and mid-cap companies, and a trend that is worth paying attention to.

My contention is that, ultimately, when the final chapters of the AI book are written, that actually small companies could be viewed as the prime beneficiaries, because they’re inherently less profitable businesses. They don’t have the scale that large-cap competitors do. But if you start at a lower point of operating margins, any incremental expansion due to the productivity gains from AI is disproportionately beneficial to your earnings growth. So, if the average small-cap company has 5% operating margins, and they can expand their margins by 200 basis points because of AI investments, that’s a 40% increment to your earnings growth, the 2% on the 5%. If you’re a large-cap company and you’ve got 20% operating margins, that same 2% incremental margin expansion only delivers a 10% growth in earnings. And so, as we see the second-order effects play out, I would make the argument that investors should keep their minds and eyes open to the fact that small companies could be beneficiaries.

Castleton: Great. So, it’s clearly a long tailwind for AI. This will be played out over many years, if not decades, but it sounds like starting to see some of those second-order beneficiaries play out today. And it’s important to be picking the right ones and taking advantage of that, sounds like. Absolutely. Yep, OK.

Demain: And I would also say, and avoiding the losers, right? I mean, you know, when the car came along, it was hard to pick the car company that was going to win, but you knew the buggy-whip manufacturer was going to go out of business. And I think there are some… Yeah, there’s some analogies there in the public markets as well, and we want to steer clear of those buggy-whip manufacturers.

Castleton: Yep, great. So, let’s look forward then just to the next remaining [months] of this year, but then into next year. Jonathan, whether it’s the economy or fundamentals, what is it that you are looking for to hopefully sustain this rally within small caps?

Coleman: Well, what gets us excited is that the starting point for valuation is very attractive for small caps. So, if you look over the long term, the absolute PE multiples on small companies is about at long-term averages. But on a relative basis to large caps, [they’re] significantly cheaper than we have been in most time periods. And so, I’m always a believer that the starting point of valuation can matter. Expectations have been lower for small caps for a long period of time. And then we’re starting to see some of that earnings growth acceleration in small caps. In fact, we believe that when Q3 earnings are reported, all said and done, that small-cap earnings growth could be equivalent or even maybe a little better than large cap. And we think that could be an important catalyst.

Castleton: OK, and Brian, midcaps … they have not kept up as much as small caps this year, but clearly still put up a decent high-single-digit performance. What are you thinking about and looking for going ahead?

Demain: Yeah, I mean, I do think the elephants in the room are the giga-cap U.S. stocks. And I think the aggregate market cap of the Russell Mid-Cap Growth and Value [Index] is about 12 or 13 billion. And you put together two or three giga-caps, and that’s 800 mid-cap companies equals three of those. And so, I would say that any change in the narrative on the U.S. giga-caps, I think would be a big tailwind, not just for midcap, but for small cap and for value and for international and really everything. And it is worth noting that those businesses are growing slower than they have historically. They’re still growing well. They’re becoming wildly more capital intensive. And they’re becoming much more competitive with one another than they have been historically. I’m not a large-cap expert, so I don’t have a call on those stocks, but it’s just … it is important to kind of watch that dynamic, because it’ll influence things down in cap.

I’d also point to, obviously we have the rate-cutting cycle, a strengthening economy. And a broadening out of economic growth would be a powerful tailwind. And so, there are a number of different factors to look at. And I guess the last point I’d make is, even if small and midcaps were to return in line with large caps, I think they do provide an important diversification benefit, just given how concentrated the broader U.S. market has become in a small set of companies with a sort of similar theme. That theme has worked really well, and I hope it continues to work well, but were it to not, there would be value in diversification simply in kind of owning small and midcaps.

Castleton: Yep, and clients are always looking for that. They don’t necessarily feel comfortable owning these big mega-cap names only. So, you’ve painted the picture, both of you, on how staying domestic, down in cap, there’s tons of growth opportunities. It’s being mindful on capturing the right ones at this point in time as we see these trends play out over a long duration of years, but clearly could be a beneficial add to portfolios as diversifiers. So, thank you both for laying that out.

Demain: Thank you.

Castleton: And thank you all for listening to this conversation. We hope you found it insightful. For more insights from Janus Henderson, you can download other episodes of Global Perspectives wherever you get your podcasts or visit janushenderson.com. I’ve been your host for the day, Lara Castleton. Thanks. See you next time.