Just about 10 “mega-cap” firms have driven more than 80% of the S&P 500’s growth in 2023. For some, that’s proven to be a source of robust returns, but that statistic also means heightened concentration risk for everyone. Is now, then, the time to take a closer look at the case for mid and small-cap stocks? They may offer more than just diversification against a top-heavy S&P 500, as discussed during VettaFi’s recent Equity Symposium.
VettaFi Vice Chairman Tom Lydon hosted a panel on mid and small-cap (SMID) stocks during the Symposium titled “The Case for Investing in Mid and Small-Cap Stocks Today.” The panelists, SS&C ALPS Advisors SVP, Director of ETF Portfolio Management & Research Andy Hicks, and VanEck product manager and CFA Coulter Regal, each took the opportunity to talk about where investors could look in the small and mid-cap space right now.
Viewers had the opportunity to respond to a poll asking how much their current client portfolio had allocated to SMID cap stocks. Respondents shared that 40% of them had between 10%-20% allocated to SMID stocks, while 30% had between 6%-10% allocated. Recent data from VettaFi shared during the discussion showed a clear emphasis on growth over value among SMID ETFs on VettaFi platforms, as well.
Asset Manager Views on Mid and Small-Cap Stocks
“There is a lot of interest in small and mid-cap companies out there,” Regal said. “There is documented outperformance versus large-caps when you go back decades and decades. It hasn’t played out like that over the last few years, but I think more and more people are starting to wake up to the opportunities in small caps now.”
For Hicks, the dominance of the top seven to 15 firms has stemmed in part from market complacency. His firm has noted to advisors that they should keep an ear to whispers of a recession while also paying attention to earnings revisions in the cards for small caps next year.
“Quality matters in small cap. It’s a very volatile and cyclical sector,” he said. “When you’re reaching in this space beyond active management, you need to layer on some smart beta factors.”
“There are four quality factors that they lay on specifically in OUSM,” Hicks added, pointing out the ETF’s use of high return on assets (ROA) as well as its use of high dividend growth, low volatility, and dividend yield.
Are Small Caps Undervalued?
Data shared during the conversation underlined that small-cap firms may be attractive right now relative to the median. The MSCI USA Small Cap index, for example, trades at a -1.5% price-to-earnings multiple difference compared to its median of 4.2x. The MSCI ACWI ex USA Small Cap – ACWI ex USA index, meanwhile, sits at 0.1X compared to its median value of 1.3x. Those numbers suggest that smaller firms may have attractive valuations for curious investors.
“I think there’s been such a run-up in these large-cap tech companies that people are starting to think about valuations; is it starting to get a bit frothy up top here?” Regal noted. “There’s been a lot of fear and uncertainty around economic slowdown and these smaller-cap companies tend to take a brunt of that force.”
“I think now is kind of where we’re starting to see some clients think about maybe allocating some of this beaten-down area as we seem to have reached the peak of the interest rate rising cycle and [with] potential on the horizon that there might be a recovery in the future,” he added.
Mid and Small-Cap Stocks in ETFs
Whether for concentration risk diversification or their own merits, mid and small-cap stocks may appeal. Investors can consider ETFs like the ALPS O’Shares U.S. Small-Cap Quality Dividend ETF (OUSM), which invests in small-cap firms that meet dividend and quality screens. OUSM has returned 7.8% year to date, charging 48 basis points (bps).
The VanEck Morningstar SMID Moat ETF (SMOT), too, may intrigue investors, which targets firms with strong “moats” within their areas that protect their competitive advantages. It tracks an index of two subindexes, small and mid-cap, with attractive valuations on top of those moats. SMOT has returned 6.8% YTD for a 49 bp fee.
Whichever direction investors choose, mid and small-cap stocks may deserve a place on their radars. OUSM has just a 9% overlap with SMOT, Hicks noted, allowing investors to pair the two. Keep an eye out for more of VettaFi’s Equity Symposium coverage for more on equity views entering late 2023.