Small caps are the next big thing

07 Dec 2023

Article written by Scott Haslem. Published in The Australian Financial Review December 6, 2023.

A year ago few, if any, would have forecast that in 2023 the US equity market would rise 18 per cent (year to date) at the same time as US 10-year bond yields cracked a 17-year high of 5 per cent. Global equity markets have defied expectations this year.

To many analysts and investors, equity markets generally look expensive, if not in absolute terms, at least relative to yields on offer in fixed income and other less volatile alternative assets.

By buying small caps, investors are trying to harness the next generation of large-cap companies, thereby beating the index. Simon Letch

Of course, perspectives on valuations are being impacted by concentration bias. Global indices, both in the US and Europe, are being distorted by extreme concentration among just a handful of stocks.

In the US, the Magnificent Seven explain a large share of 2023 returns, as the euphoria surrounding artificial intelligence is priced into the relevant stocks.

Without them, US equities would be up only 8 per cent this year (not 18 per cent). As such, valuations are not as stretched as they may seem at face value. And outside the US, most equity markets look fairish, being at or near their average give-year valuations.

We think this warrants an at best neutral or balanced stance toward equities for now. There are still reasons to be cautious about adding equity exposure, given consensus earnings outlooks (up 12 per cent in the US) don’t quite marry with a weakening economic outlook.

Yet, like in other asset classes, turning points in the cycle (as policy rates peak) are often accompanied by volatility. This often favours a focus on tactical opportunism relative to the more traditional approach of simply allocating more or less to a particular asset class.

Within equities, there are likely still significant opportunities outside the mega-cap cohort. Indeed, small and mid-cap stocks are an area that is looking increasingly interesting for investors in 2024.

Given they are smaller than the large or mega-cap stocks, these companies arguably have more potential to grow (and be more volatile), adding returns (or alpha) to portfolios.

In some sense, by allocating to these companies, investors are trying to harness the next generation of large-cap companies, thereby beating the index.

This is also a significant part of the market that gets less investor attention, despite small and mid-caps almost evenly sharing about 30 per cent of the weight of world equity indexes. However, we think there are a few reasons that warrant a closer look in the year ahead.

Firstly, small and mid-cap equities provide protection against concentration risk. For many Aussie investors, their global equity exposure is dominated by a range of large-cap mega stocks.

But the global small and mid-cap universe is far more diverse, with no single names, groups of names, or sectors driving performance.

Secondly, there are more opportunities for good managers to outperform. With significantly less analyst coverage of stocks in the small to mid-cap universe compared to large caps, there are information inefficiencies that can be exploited by some rigorous bottom-up research.

Thirdly, returns have outpaced large-cap equities by 0.5 per cent per year over the past 20 years. Of course, the reason this part of the market may currently be garnering less attention is that small caps tend to lead large caps during market upturns, as well as during market downturns. And there remains significant uncertainty about just how weak the next six to 12 months may be for economies.

But the fourth reason making the case is that small and mid-cap stocks are already at a significant discount to large-cap stocks, given the past year’s performance of large caps.

Recent volatility has led investors to seek safety in larger companies with bigger balance sheets and greater access to liquidity.

For many, global small and mid-cap stocks are underrepresented in their portfolios, despite their long-term outperformance. This is likely to reflect their greater economic sensitivity and higher volatility. It also likely to reflect recency bias, given large caps have outperformed of late.

Yet, Sophisticated investors are increasingly recognising local and global small and mid-caps as a sector that merits an allocation. Moreover, given the information inefficiencies, as well as greater dispersion across share prices, business models and geography, they are also seeking out active managers rather than passive ETFs.

Finally, for those who see near-term macro weakness as a headwind to small-cap exposure, now is an opportunity to research good fund managers to facilitate timely investment when the cycle turns.

Of course, mid-cap stocks may well be in their ‘sweet spot’ today, given they offer more growth opportunities than large caps, but with less economic sensitivity and volatility than small caps.

Subscribe to insights and observations

Please provide your first name.
Please provide a valid email address.
Please provide a phone number.
By subscribing to insights and observations you acknowledge you have read and agree to our privacy statement