US small and mid-cap stocks (SMIDs) have produced disappointing returns compared to large caps since the beginning of the year.
By the end of the first quarter of 2017, the large cap S&P 500 index had rallied 5.5 per cent, comfortably ahead of the returns of mid and smaller capitalised stocks. The S&P 400 Midcap index managed only a 3.6 per cent gain and the Russell 2000 index of smaller companies fared even worse with a disappointing return of 2.1 per cent.
Small and mid-cap stocks had a brief period of strong outperformance after Trump’s surprising victory in November.
A key reason for the rally was the revelation that the new president planned to sharply reduce corporation tax.
Companies in the small and mid-cap indices derive a far greater proportion of their sales from the domestic US where tax rates are higher than in many overseas markets where the US multinationals have operations. So smaller companies stood to be the greatest beneficiaries of the new President’s proposals. But in the aftermath of the difficulties experienced by the new administration to repeal Obama’s Affordable Care Act – which would have provided some of the savings required to finance cuts in corporation tax – investors seem to have lost confidence in the prospect of meaningful tax reform and the enthusiasm for small and mid-cap stocks has waned.
We think the ensuing period of underperformance has brought valuations back to attractive levels again
According to the data shown by Thomson Financial Reuters above, the Russell 2000 index is priced at only a 25 per cent premium to the S&P 500 using 2018 earnings forecasts, despite the fact that companies in the index are forecast to have a growth rate exceeding two and a half times.
The chart below show shows how the relative P/E ratio of the S&P 600 Small Cap index has now fallen to long term averages and which, at the very least, suggests that small caps are not expensive in historical terms.
The argument against small and mid-cap stocks is based on the fact that the economic cycle is long in the tooth at over eight years (with the longest period in recent history being the period of the “roaring 90s” from 1991-2001). If this is true, investors might be expected to start rotating into blue chip stocks which would offer greater protection going into a downturn. In addition, large caps are typically less impacted by any tightening in credit conditions as it is easier for a blue-chip company such as IBM to raise capital.
The problem with this view is that it does not take account of the very unusual nature of the current expansion.
The economy has grown at a very anaemic rate compared to prior cycles and as a result, interest rate increases should be far less pronounced. In addition, the likely prospect of fiscal stimulus this year or in 2018 should prolong the recovery making a switch out of SMIDs potentially premature – especially given where valuations are.
Other factors in favour of SMIDs include the mergers and acquisitions backdrop and the potential for a slowdown in corporate earnings growth from a squeeze on margins.
The merger & acquisition cycle should continue to be supported by the still low level of interest rates and the fact that many large cap acquisitors remain flush with cash. A number will be looking to boost their growth by buying smaller competitors to expand their product offerings.
Smaller companies as an asset class could also be revalued higher if investors conclude that large cap profit margins are under pressure from higher input costs such as labour or fuel.
It is easier for smaller companies to grow sales and earnings faster from a low base than mature companies which already dominate their markets. If decent earnings growth becomes scarce again, companies in the Russell 2000 index are usually the first area where investors screen for growth.
The case against small and mid-cap stocks is based on the possibility of the US entering an economic downturn in the next 12-18 months. However, with recent data showing that growth appears to be accelerating (with strong reads on manufacturing and housing activity) such a scenario is looking increasingly unlikely. Our sense is that we are beginning to see a good period for SMIDs and expect further outperformance as the year progresses.
Nick Ford is manager of the CF Miton US Opportunities fund. The views expressed above are his own and should not be taken as investment advice.