Written by LGT Crestone Senior Funds Analyst - Traditional Jessica Clifford and LGT Crestone Investment Analyst Rhys Thomas

Given the outperformance of global large-cap equities versus small and mid-caps, there has been a growing valuation argument in favour of small to medium-sized companies. The valuation discount of small- and mid- (SMID) cap equities versus large-caps is now more attractive than it has been in over a decade. However, despite their potential to generate returns in excess of the benchmark, allocations to SMID-cap equities are still typically under-represented in investor portfolios.

In this report, we highlight our thinking around harvesting the size premium associated with SMID-cap equities, the ways that investors can allocate to this part of the market, risk management, and considerations around market timing.

What do we mean by small and mid-caps and what role do they play in a portfolio?

Global SMID-cap companies play a ‘growth’ role in portfolios, offering investors the opportunity to add alpha. Because they are smaller than large-cap equities, they have more potential to grow, as they are typically earlier on in their growth journey. By allocating to these companies, investors are trying to harness the next generation of large-cap companies and can, therefore, harness alpha—or returns in excess of the benchmark. This is often referred to as a ‘size premium’, and has been shown to contribute to portfolio alpha, when adjusted for risk over time.

The MSCI World Small-Cap index comprises the smallest 14% of companies across 23 developed markets. The smallest company in the index has a market cap of around $300 million, but the average market cap of the index is currently $1.4 billion. The MSCI World SMID-Cap index is a combination

Figure 1: How MSCI defines the small, mid and large-cap world

What are the benefits of investing in small and mid-caps?

A more diverse index with less leader concentration

For Australian investors, their international equities exposure is often dominated by large-cap companies. The MSCI World index, which is a common benchmark for investors, is heavily influenced by several mega-cap technology companies. This trend of greater index concentration has persisted for a number of years. In contrast, the global SMID-cap universe of stocks is far more diverse at a stock level, with no single names, groups of names, or sectors driving performance. As an example, the top 10 positions in the MSCI World index represent 20.1% of the index, whereas the top 10 in the MSCI World SMID-Cap index is 2.4% (as at September 2023).

Less analyst coverage means a greater opportunity to add alpha

When looking across the universe of managers, global active managers have been able to achieve alpha (i.e., outperformance of the benchmark) by investing in global SMID-cap companies. With significantly less analyst coverage of stocks in the SMID-cap universe compared to large caps, there are market and information inefficiencies that can be exploited by rigorous bottom-up research and active management.

Historically, returns have outpaced large-cap equities, although timing matters

When we consider both risk and return, we can see that returns on SMID-cap equities have outpaced large-cap equities, as shown in Figure 2 below. However, timing matters, as shown in Figure 3, as they tend to lead large caps during market upturns, as well as during market downturns. More recently, there has been a strengthening valuation argument in favour of greater SMID-cap allocations, with this part of the market currently offering an attractive valuation discount versus large-cap equities (see Figure 4).

Figure 2: SMID-cap equities have outpaced large-cap equities over the long term

Figure 3: Smaller caps tend to lead large caps through various parts of the cycle

Figure 4: Currently, global small and mid-caps are offering an attractive valuation discount

Although volatility can be high, we believe this is commensurate with the returns on offer

While SMID-cap returns have been higher than large caps, this return does come at the price of slightly higher volatility. This should be expected and reflects the additional risk premium, or compensation, that investors demand of global SMID-cap companies versus large caps. Some of these risks include liquidity, balance sheet, economic sensitivity, and product life cycle.

In more volatile markets, or environments of weaker economic growth, investors will generally allocate a disproportionate share of their portfolios towards larger companies with bigger balance sheets, greater access to diverse sources of funding, and more liquidity. This can result in bigger drawdowns of SMID-cap companies vis-à-vis their large-cap counterparts. However, when managed in an active way, we believe the returns and diversification benefits are commensurate with the additional volatility added to portfolios.

Figure 5: Risk-reward over the past 20 years

Source: Bloomberg. Data as at November 2023. Indices represent annualised monthly returns for the MSCI World Small-Cap NR AUD, MSCI World Mid-Cap NR AUD and MSCI World NR AUD indices.

Small and mid-caps are typically underrepresented in investor portfolios

Despite their outperformance of global large caps over the long term, and despite there being several ways to gain exposure to global SMID-caps, they are typically underrepresented in investor portfolios. Investor appetite has typically been hampered for a number of reasons:

• Their potential to add portfolio risks (e.g., liquidity and economic sensitivity).
• Their potential for increased volatility.
• Recency bias (where SMID-caps have significantly underperformed their large-cap peers over the past decade).

Mid-cap equities represent the ‘sweet spot’

When it comes to allocating at the portfolio level, some may argue that investors can be indifferent to how much exposure they should have to global, small and mid-cap equities. This is because allocations are largely driven by the prevailing macro backdrop and manager selection.

Although there are periods when an increased exposure to small-caps is warranted, especially in the recovery phase of an economic cycle, mid-cap equities are often viewed as representing the ‘sweet spot’. They offer more growth opportunities than large caps, and less risk and volatility than small caps.

Of course, economic conditions and valuations play an important role. However, mid-cap managers that can take advantage of small-cap growth, whilst not being limited by a mandate to sell companies as they cross a certain size threshold, can capture a disproportionate share of the value created as companies mature and grow in size.

Although some may argue that small caps offer better growth potential than mid-cap equities, when assessing the underlying constituents, both segments have produced a remarkably similar earnings growth trajectory over the past 10 years.

Figure 6: Small and mid-caps have shown a similar earnings growth trajectory

The need for active management

Global SMID-cap companies are increasingly being recognised by investors as an asset class that warrants an allocation. Over the past decade, access to and the quality of SMID-cap funds have continued to improve. Additionally, because of the market and information inefficiencies associated with these companies, as well as greater share price, business model, and geographic dispersion, we advocate a more active approach to investing, rather than a passive index or exchange-traded fund exposure.

More nuanced, however, are some of the key characteristics investors should look for when allocating to an active manager. These include the ability to achieve portfolio diversification, as well as global research capabilities. Additionally, multiple in-house factor or style exposures (e.g. large cap, value, or growth), cycle experience, risk management protocols, and multi-asset capabilities are all factors that investors should consider.

IMPORTANT NOTE

This document has been prepared by LGT Crestone Wealth Management Limited (ABN 50 005 311 937, AFS Licence No. 231127) (LGT Crestone Wealth Management). The information contained in this document is of a general nature and is provided for information purposes only. It is not intended to constitute advice, nor to influence a person in making a decision in relation to any financial product. To the extent that advice is provided in this document, it is general advice only and has been prepared without taking into account your objectives, financial situation or needs (your Personal Circumstances). Before acting on any such general advice, we recommend that you obtain professional advice and consider the appropriateness of the advice having regard to your Personal Circumstances. If the advice relates to the acquisition, or possible acquisition of a financial product, you should obtain and consider a Product Disclosure Statement (PDS) or other disclosure document relating to the financial product before making any decision about whether to acquire it.

Although the information and opinions contained in this document are based on sources we believe to be reliable, to the extent permitted by law, LGT Crestone Wealth Management and its associated entities do not warrant, represent or guarantee, expressly or impliedly, that the information contained in this document is accurate, complete, reliable or current. The information is subject to change without notice and we are under no obligation to update it. Past performance is not a reliable indicator of future performance. If you intend to rely on the information, you should independently verify and assess the accuracy and completeness and obtain professional advice regarding its suitability for your Personal Circumstances.

LGT Crestone Wealth Management, its associated entities, and any of its or their officers, employees and agents (LGT Crestone Group) may receive commissions and distribution fees relating to any financial products referred to in this document. The LGT Crestone Group may also hold, or have held, interests in any such financial products and may at any time make purchases or sales in them as principal or agent. The LGT Crestone Group may have, or may have had in the past, a relationship with the issuers of financial products referred to in this document. To the extent possible, the LGT Crestone Group accepts no liability for any loss or damage relating to any use or reliance on the information in this document.

This document has been authorised for distribution in Australia only. It is intended for the use of LGT Crestone Wealth Management clients and may not be distributed or reproduced without consent. © LGT Crestone Wealth Management Limited 2023.