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Why Global Smid-Caps Now?

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15 July 2024

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TT Global SMID-Cap Strategy: delivering alpha

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Learn why we believe that now is an ideal time to be allocating to global smid-cap stocks. 

Evidence shows that smid-caps outperform large-caps over the very long term. In the US, where data stretches back particularly far, a dollar invested in 1926 in large-caps would have grown to $9,092 by 2023, while a dollar invested in small-caps would have become $58,201 (UBS). Studies such as Dimson (1988), Hawawini and Keim (2000), Dimson, Marsh and Staunton (2002), and Schwert (2003) confirm that this phenomenon is present in almost every country that researchers have analysed. On a global basis, MSCI smid-cap beat MSCI large-cap by ~70% in the two decades to 2020. However, relative performance tends to follow multi-year cycles, and since the pandemic, large-caps have outperformed by over 10%. This is unsurprising as they often perform well during periods of uncertainty and below-trend economic growth, where investors pay a premium for more established businesses with higher earnings visibility. Historically, following similar periods of underperformance, smid-caps have gone on to outperform significantly over the subsequent 5 years. We believe that the stars are now aligning for a multi-year period of sharp smid-cap outperformance. In the following piece we outline why. 

An ideal environment for smid-caps…

In the past, smid-caps have tended to perform best coming out of a recession, or where the global economy is strong. This is partly because smid-caps generally have lower margins and higher operating leverage than large-caps, meaning that they have greater gearing to the economic cycle. As can be seen from the charts below, smid-cap relative performance is highly correlated to leading economic indicators.

European small-caps versus PMI new orders

European small-caps versus PMI new orders

Source: Key conclusion July 2024 © UBS. All rights reserved. Reproduced with permission. May not be forwarded or otherwise distributed.

UK small-caps versus PMI new orders

UK small-caps versus PMI new orders

Source: Key conclusion July 2024 © UBS. All rights reserved. Reproduced with permission. May not be forwarded or otherwise distributed.

Although the US has not experienced an outright recession, it has seen recessionary-type conditions in some segments of the economy, with a 25% decline in new housing starts, for example. There have also been technical recessions in the UK and some European markets. We believe there are several reasons that the global economy should strengthen from here.

Emerging into a post-Covid world beset by logistics constraints, companies reacted by holding more inventory than normal. Then inflation and higher interest rates choked off demand, leaving companies with far too much stock, forcing them to scale back production. However, inventory levels are now healthier, meaning that production should pick up, even without an acceleration in demand. We are already seeing this in a wide range of industries, from semiconductors to bicycles and footwear. Moreover, there are reasons to suggest that end demand will in fact accelerate. Consumers in advanced economies have strong balance sheets, with debt-to-disposable-income at post-GFC lows in the US and UK, for example. Meanwhile, inflationary pressures are subsiding, real incomes are growing, and interest rates are set to fall.

Incidentally, lower rates have other beneficial effects that are particularly relevant for smid-caps. Firstly, smid-caps have higher floating-rate debt and therefore benefit more directly from falling interest rates. Secondly, as rates are cut, M&A activity is likely to pick up, particularly at a time when private equity is sitting on a $2.6 trillion mountain of dry powder. Over the past 30 years, 96% of publicly-listed M&A targets in the US have been smid-cap firms, with an average premium paid of 50% in 2023.

…turbocharged by attractive relative valuations

The outperformance that we expect due to an improving economic environment should be enhanced by relative valuations. MSCI ACWI smid-cap is currently trading at 15.8x 12-month blended forward earnings, an 8% discount to its 10-year average of 17.1x. By contrast, MSCI ACWI is trading at 17.8x 12-month blended forward earnings, a 10% premium to its 10-year average of 16.1x. Over the past decade, smid-caps have traded at an average premium to large-caps of 6%, yet today they sit on a 12% discount. In the US, Europe and the UK, smid-caps are trading at least one standard deviation ‘cheap’ versus large-caps on a P/E basis. 

US small-cap relative to large-cap 12-month forward P/E

US small-cap relative to large-cap 12-month forward P/E

Source: Key conclusion July 2024 © UBS. All rights reserved. Reproduced with permission. May not be forwarded or otherwise distributed.

European small-cap relative to large-cap 12-month forward P/E

European small-cap relative to large-cap 12-month forward P/E

Source: Key conclusion July 2024 © UBS. All rights reserved. Reproduced with permission. May not be forwarded or otherwise distributed.

UK small-cap relative to large-cap 12-month forward P/E

UK small-cap relative to large-cap 12-month forward P/E

Source: Key conclusion July 2024 © UBS. All rights reserved. Reproduced with permission. May not be forwarded or otherwise distributed.

These discounts are difficult to justify, with smid-cap companies arguably deserving a premium because of their superior growth prospects. Indeed, since MSCI smid-cap index data became available in 2009, smid-cap EPS has grown at a 9% Cumulative Average Growth Rate, versus 7% for large-caps. One way that large-caps often make up for their slower growth is by offering a higher yield, yet the dividend yield of MSCI ACWI smid-cap is currently 0.5% higher than that of MSCI ACWI, a rare anomaly. 

Beating the best

Despite these arguments, given the exceptional performance of the Magnificent 7 in recent years, and their leading positions in fields such as AI, investors are right to ask whether smid-caps can match or even beat the returns from these global champions in the future. Thankfully, history is on smid-caps’ side. Of all the companies that have ever become a global top 10 stock by market capitalisation, only 25% have continued outperforming following entry to that elite club. Intuitively, this is unsurprising. Just as gravity inexorably increases in line with an object’s mass, the law of large numbers dictates that it will become increasingly difficult for a company to sustain its growth rate as it becomes bigger. Once companies reach market capitalisations that are more akin to the GDP of entire countries, finding incremental opportunities that can have a material impact on growth becomes exceedingly challenging.

In the 1980s the global top 10 list was dominated by oil companies, whilst in the 1990s it was the turn of Japanese financials. Today’s top 10 is largely made up of tech companies, and although they may be better positioned than their historic counterparts in the sense that they are highly profitable and dominant in areas such as AI, the law of large numbers is extremely powerful. Not every tech company that makes it into the list goes on to outperform; for every Microsoft, there is a Lucent. In fact, given the dynamic and ever-changing nature of technology, there may even be more churn at the top than in the past. To illustrate the point, the Magnificent 7 were immediately preceded by the FAANGs. This included Netflix, which has since dropped out. Clearly there is no guarantee that these stocks will continue to be “magnificent”. At least some of this group already look vulnerable, with Tesla seeing negative earnings revisions amid challenges in the EV sector. Even following its recent correction, Tesla still trades on 92x 2024 earnings and 10x book value. Its market cap remains close to 2.5x that of Toyota and over 10x that of VW. If these mega-cap stocks do begin to underperform, this will represent a bigger drag to market capitalisation weighted indices than we have seen historically, since index concentration levels have become extreme. There have only been two times where market concentration has been at similar levels to today – 1962 and 2000. In the decade following those peaks, small-caps significantly outperformed large-caps. In the 1960s they delivered twice the return of large-caps, whilst in the 2000s they produced 4% annualised returns versus negative returns for large-caps. To be focused solely on the largest-cap companies in the world is to bet strongly against history, and we would therefore advocate that global investors should have meaningful exposure to the smid-cap part of the market.

We have argued that the current macro backdrop sets the scene for a multi-year period of sharp smid-cap outperformance. In our view they are one of the best plays on the outlook of robust economic growth, disinflation and rate relief. This outperformance should be turbocharged by the aforementioned attractive valuations and light investor positioning in the smid-cap space. Falling interest rates should not only improve risk appetite and therefore accelerate a smid-cap re-rating, but also boost M&A as the cost of capital comes down. Whilst we expect the asset class in general to perform well, we also see significant opportunities for discerning stockpickers to capture alpha as smid-cap stocks are often under-researched and overlooked, leading to structural inefficiencies. Indeed, large-cap stocks have on average four times more sell-side analysts covering them than smid-caps, which leaves many smid-cap stocks offering a powerful combination of value, growth and quality. We believe our strategy is perfectly placed to capture this alpha opportunity, as we outline in this piece. 

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