Should You Consider Small- and Mid-Cap Stocks?

If you recently checked out the stock prices in your investment portfolio, you might have noticed a substantial gain over time in major technology giants like Apple Inc., Amazon.com Inc., Microsoft Corp. and Tesla Inc. Of course any investor would welcome a rise in value of their large-capitalization stock holdings, but it may also be worth exploring opportunities among small-cap and mid-cap companies. Investing in such businesses could be an excellent strategy to diversify your portfolio, help reduce risk and potentially outperform the broader markets over the longer term. Let’s talk about why.

Asset class overview

Small-cap companies typically have a market capitalization ranging from $250 million to $2 billion. They can offer high growth potential, although with higher risk, since they’re often less established and stable than their large-cap counterparts. Growth in small-cap businesses usually stems from operations in high-growth industries during their early development stages, but their acute sensitivity to economic conditions makes them more vulnerable to market fluctuations.

The relative lack of Wall Street analyst coverage presents the chance to discover hidden gems with significant upside potential, whereas the heavyweight companies in the market are under constant scrutiny and provide little opportunity for major surprises. Despite underperforming the market this year, small caps have managed a year-to-date return of 0.87%.¹

Mid-cap companies, typically characterized as having a market capitalization between $2 billion and $10 billion, possess a more established presence compared to small caps. Although they have the potential to outperform large caps, they may also exhibit relatively higher volatility. Mid-caps strike a balance between growth potential and stability. Currently, they have underperformed the market with a year-to-date return of 2.73%.²

When do these assets perform well?

The performance of small- and mid-cap companies is typically tied to the state of their home economy. During periods of economic expansion, these companies can experience substantial growth opportunities, as positive changes in economic conditions increase demand for their goods and services. An uptick in mergers-and-acquisitions activity is also considered a good sign, given that small companies become attractive acquisition targets leading to potential appreciation in market price, while the strong appetite for such companies by competing bidders may drive the acquisition price higher.

Smaller companies flourish during economic recoveries but pose higher risks during economic downturns. They tend to underperform before a recession but start outperforming midway through the recession and perform strongly during the recovery phase. In many cases, small caps tend to outperform in the two years following a recession.

Performance history of small caps and mid-caps

With investors anticipating an economic slowdown, small- and mid-cap stocks faced a challenging year in 2022, along with the rest of the market, experiencing losses of approximately 20% and 17%.³ However, this has generally led smaller companies to have their most attractive valuations since the technology bubble of 1999–2001, when compared to their larger-cap peers.

During the seven-year period after the market peak in March 2000, small caps gained more than 70%, while large caps gained less than 10%.⁴ Since the tech bubble burst, small caps have consistently outperformed large caps, with an average yearly outperformance of more than 400 basis points (i.e., four percentage points).⁵ Furthermore, a current gradual decline in inflation may benefit small- and mid-cap companies.

Are small- and mid-cap companies appealing right now?

Many analysts expect some degree of recession following this extended period of high interest rates that’s been negatively impacting economic growth, which is unfavorable for small caps and mid-caps. However, with inflation decreasing, consumer spending thriving and a fairly healthy labor market, we may be able to avoid a recession and opportunistically add small- and mid-cap companies to an investment portfolio. Small and mid-caps execute the bulk of their sales domestically, so when the home economy is strong or on the upswing, they tend to perform well. Some forecasts indicate that small caps could deliver 12% annual returns over the next decade, compared to only 5% for the large-cap S&P 500 Index.⁶

Presently, we believe both small and mid caps appear undervalued on a relative basis, making them enticing investment prospects. Current valuations already account for significant negative news, while a potential slowdown in inflation, along with lower interest rates, could benefit small- and mid-sized companies. These firms are often highly leveraged to promote growth and expansion, so reduced borrowing costs (because of lower interest rates) could lead to improved profitability and performance. If the market manages to avoid a recession, small and mid-caps could prove to be excellent investments. Given a well-performing market and sustained investor optimism, small caps and mid-caps may present a higher-risk, higher-reward option for diversifying an investment portfolio. If you’re interested in exploring such opportunities, contact your Corient Wealth Advisor.

¹ Russell 2000 Index, as of market close September 22, 2023
² Russell Midcap Index, as of market close September 22, 2023
³ https://www.spglobal.com/spdji/en/commentary/article/us-equities-market-attributes/#:~:text=For%20the%20three%2Dmonth%20period,down%206.24%25%20(4.38%25).
⁴ https://www.schroders.com/en-us/us/individual/insights/outlook-2023-us-small-and-mid-caps-can-outperformance-continue/
⁵ https://am.jpmorgan.com/gb/en/asset-management/per/insights/portfolio-insights/investment-trust-insights/global/observations-from-the-us-equity-desk-is-it-time-for-a-small-cap-cycle/
⁶ https://www.bloomberg.com/news/articles/2022-09-08/bofa-says-small-caps-cheaper-than-since-the-dot-com-bubble#xj4y7vzkg

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