Dynamic, ability to generate alpha and under-researched opportunities are just three of the reasons that US small- and mid-caps could outperform as the economy recovers from Covid-19, according to Schroders’ Bob Kaynor.
In the US, small-cap stocks are generally defined as having a market capitalisation below $3bn while mid-cap stocks can be as large as $15bn. Looking at the market capitalisation of the US as a whole, less than 15 per cent is comprised of small-and mid-cap stocks.
Kaynor, head of US small -and mid-cap equities at Schroders, said: “While market movements may cause the defining market cap range to vary over time, the characteristics that make this part of the market appealing for active management remain consistent.”
Below, the portfolio manager gives his four reasons for investing in the asset class.
Under the radar opportunities
“US small- and mid-caps can be a richly rewarding space in which to invest,” said Kaynor. “It offers investors the opportunity to discover misunderstood or poorly-known companies, while still providing sufficient trading liquidity to help mitigate risk.”
He added that while the large-cap space is highly efficient with multiple analysts covering a singe stock, as you move down the capitalisation scale the coverage becomes stretched and this creates a substantial opportunity.
Performance of average US small-cap fund vs index over 10yrs
Source: FE Analytics
“In an increasingly digital world where identifying information inefficiency is more challenging, the small- and mid-cap space remains fertile ground,” he said.
“Perhaps this is one of the reasons that 49 per cent of active managers in US small- and mid-cap have outperformed their benchmark over the last 10 years versus only 39 per cent in large caps.”
Small and nimble
One of the hallmarks of the asset class, according to the portfolio manager, is how dynamic these companies can be in adapting their business models.
“Smaller companies have the ability to adapt and invest in new lines of businesses that can have meaningful impacts on their enterprise in a short period of time,” he said.
“Changing course for a yacht is a lot easier than for a container ship, as recent events in the Suez canal have demonstrated.”
Complement to a large-cap holding
It’s well documented that over longer periods, small-caps generally outperform large-caps.
This is also true of the US and, while small-and mid-cap stocks tend to outperform during economic recoveries, large-caps tend to outperform during periods of economic uncertainty.
“After over a decade of economic growth that failed to achieve ‘escape velocity’, the paradigm is finally shifting,” he said. “The more domestically focused small- and mid-cap universe is poised to benefit disproportionately as the domestic US economy experiences the strongest growth in a generation.”
Performance of Russell 2000 vs S&P 500 over 20yrs
Source: FE Analytics
“We see a sustainable tailwind to this US recovery, fuelled by unprecedented fiscal and monetary stimulus working in unison, capital expenditure to secure supply chains, healthy corporate balance sheets, and an unsustainably high consumer savings rate.”
Kaynor added that given that these companies tend to have different periods of outperformance, it’s best to adopt a long-term strategy which includes both large-and small-cap allocations.
Greater opportunities in finding alpha
Alpha, otherwise known as excess returns earned on an investment above the benchmark return, is another difference between the mid-and large-cap indices, according to Kaynor.
Sector correlations with the benchmark are lower in mid-cap versus large-cap. For example, financial stocks in the large-cap universe have a 0.70 five-year correlation with the S&P 500.
However, in the Russell 2500, the correlation drops by 21 basis points to 0.49.
The top 25 large-cap companies comprise 40 per cent of the index, while just 7 per cent is in mid-caps.
“Across every sector there is a lower correlation of the underlying stocks within the sector in the mid cap space relative to large,” he said. “This lower correlation provides greater opportunity for alpha through stock selection for active managers.”
Why now?
According to analyst projections, the US economy is on a path to the strongest calendar year of GDP growth since 1965, with “earnings growth easier to find now than it has been for some time”.
Kaynor added: “After over a decade of growth being scarce and market participants paying any price, growth is now everywhere and it’s valuation that is scarce.”
Indeed, growth-oriented managers in the US who dramatically outperformed in 2020 are now lagging, with value and core managers outperforming.
“With an economic recovery underway, the more domestic and cyclical small -and mid-cap market could be poised to outperform. The economic recovery and commensurate change in market leadership is an inflection point for small and mid-caps that can last,” he finished.
“Last year was difficult, but we believe now is an opportunity to swim with the tide.”