US Small & Mid-Caps: the Heartbeat of the US Economy
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While large-cap stocks often grab the headlines, it is small and mid-caps that really represent the heartbeat of the US economy. So explained Bob Kaynor, Head of US Small and Mid-Cap Equities at Schroders, at a new Virtual Investment Summit moderated by William M. Gambardella, Head of Offshore Solutions at Morgan Stanley Wealth Management Global Investment Office (GIO).
Schroders limits the universe of US small- and mid-caps to companies with market capitalizations of between $300 million – a market capitalization of less than $300 million implies accepting a significant amount of liquidity risk – and $12 billion. These limits are flexible, as the composition of benchmark indices changes from year to year, but one could say that the weighted average is around $7 billion.
“With a lower concentration in stocks and sectors than in the S&P 500 index, it is really in the small and mid-cap companies that you can feel a slight optimism as the economy begins to reopen,” explained Bob Kaynor.
Valuations
Small and mid-cap companies are trading at multiples of 21x over earnings and around 16x over expected earnings. These figures may seem reasonable given the current level of interest rates. But it is a diversified universe, so there are several opportunities to find companies and industries that are going to experience growth that is differentiated from what large cap stocks may be signaling.
In Kaynor’s opinion, the returns that were achieved last year are explained by an expansion in multiples thanks to the significant monetary and fiscal stimulus programs that have been announced. While markets have anticipated a recovery in earnings, going forward to 2021 and 2022, it is very important that these expectations are met because high returns cannot be expected in the absence of profits.
The Focus on the Domestic Economy
When looking at the revenue composition of the small and mid-cap universe, about 22% of revenues come from other regions compared to 33% for the S&P 500 index.
The United States operates a global economy. Even in the small and mid-cap segment, many of the companies selected by Schroders in its strategy conduct part of their business internationally. As a result, the weakness or strength of the dollar could have some impact on their business. However, in general, this segment has a greater focus on the domestic economy than on the global economy. When an investor allocates a portion of his assets in this universe, he is really betting on the improvement of the US economy.
The Effects of the Biden Administration
We are currently in an environment where monetary and fiscal policies in the US are working in tandem to achieve a recovery in both financial assets and in the real economy. As we move into 2021, a transition from monetary and fiscal policy support to real growth would be needed to get the economy to reopen.
According to Kaynor, one could argue that fiscal policies promote inflation and cyclical sectors. Such stimulus could benefit the universe of small and mid-cap stocks, because unlike the S&P 500, it is less dependent on a small group of stocks with high multiples that benefit from secular growth to determine the benchmark’s returns.
The Concentration of Large-Cap Indices
When looking at the S&P 500 index, the five largest stocks by market capitalization – the so-called “FAMAGs”, Apple, Microsoft, Amazon, Facebook and Alphabet (Google) – account for about 25% of its total capitalization. By contrast, when benchmarks for the small and mid-cap universe are explored, the five largest stocks have a weight of 2.5%.
A large-cap US equity investor needs to have exposure to these five stocks. Whereas in the small and mid-cap market there is very little risk in not having exposure to any of the stocks that make up the universe. The technology sector represents 15% of the benchmark, but that percentage doubles in the large cap universe. US Small and Mid-Caps have a greater bias towards industrials, consumer goods and financials – with exposure to regional banks – again, sectors closer to the real activity of the US economy.
A Balance between Risk and Value
This universe allows the management of risk while adding value. If you look at risk-adjusted returns over a long-term horizon, you can see that they offer a higher return compared to the additional volatility they incur than elsewhere in the market. In small caps there is a higher risk trade-off for the exposure to momentum that is being sought by investing in them. Investors in this segment must have a higher tolerance for this risk. As we move towards mid-caps, the market shows a degree of inefficiency, without the need to take an excessive amount of risk, there is the opportunity to identify alpha and portfolio risk can still be managed given the diversified nature of the universe.
The industrial sector is the most heavily weighted sector within the index and probably the segment with the most opportunities. As the economy recovers, there will be increased spending on infrastructure and capital equipment, investing in improved supply chains or factory automation processes. This will impact on these companies with returns based in the real economy rather than in the financial economy.
The Technology Sector
In the technology sector, they have a preference for semiconductor production companies as opposed to rapid growth software companies, where with enterprise value-to-revenue (EV/R) multiples of 18x, they are not as attractive.
Historically, semiconductor companies were perceived as the cyclical part of the technology sector while software companies were perceived as secular growth companies. With an increased presence of semiconductors in the automated processes of other industries, such as automotive or telecommunications, this perception is changing.
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