The case for small- and mid-caps

In the wake of the global mega-cap stock run, small- and mid-cap stocks check all the boxes right now, writes Amit Goel

The case for small- and mid-caps

Global equity indexes have bounced sharply higher since March. However, not all market segments have benefited equally from the rally. Our data and research highlight that mega-cap equities (represented by the top 100 global stocks by market capitalization) have now entered overbought territory, while global small-cap equities remain oversold. For disciplined investors, such an imbalance presents a rare buying opportunity in the mid- and small-cap segments of the market.

To understand this phenomenon, we measure the mega-cap equities’ share of global equity markets. These top 100 stocks are now valued at US$30 trillion and represent an unprecedented 39% share of global market capitalization. In another extreme, the top five technology companies (Apple, Microsoft, Amazon, Google and Facebook) are now valued at approximately US$7.5 trillion, representing a 10% share of global market capitalization. This disproportionate weighting is skewing returns in most indexes and portfolios.

Strong rallies and a rapid increase in valuation multiples of mega-cap stocks are, in fact, quite common in periods of extreme market volatility. During the 2008–09 financial crisis, mega-cap equities’ share of global market capitalization increased from 30% in May 2008 to a peak of 35% in November 2008, reflecting market participants’ general preference toward mega-cap stocks for their liquidity and buffer capacity during times of market uncertainty.

Over the subsequent two years, between November 2008 and November 2010, the share of mega-cap equities retreated from a peak of 35% to a more normal level of 30%. This decrease in market capitalization was almost entirely captured by mid- and small-cap equities, as their market share increased from a low of 24% to 28%. In other words, capital was reallocated toward mid- and small-cap stocks, which grew faster than mega-cap stocks. As a result, global small-cap equities went up by a whopping 85% during those two years, outperforming every other major market segment.

Our analysis shows that we might be at a similar inflection point today in the current market recovery cycle. The share of mega-cap equities has reached a new high of 39%, while the share of mid- and small-cap equities appears to have bottomed around 24%, similar to the levels observed in 2008–09. If a sustained economic recovery persists, mid- and small-cap stocks should continue to gain more market share at the expense of mega-cap stocks.

Rebalancing toward mid- and small-cap equities is more than a tactical move. Instead, it is vital for long-term strategic allocation. Digging deeper and analyzing small-cap equities specifically highlights that they have greater capacity to grow. Over the past 20 years, the performance of two MSCI ACWI indexes shows that small-cap equities have more than quadrupled in value, significantly outperforming mega-cap equities, which were just shy of tripling in value – between August 2000 and August 2020, the MSCI ACWI Small Cap Index went up by 315% (7.4% per annum), while the MSCI ACWI Index went up by 190% (5.4% per annum).

At this point in the cycle, small-cap stocks have already lagged larger-cap equities by as much as 20% – the biggest differential in two decades. A differential of such magnitude is rare and unlikely to last, providing investors with an unusual entry point into a highly lucrative segment of the capital market.

Amit Goel is a portfolio manager at Hillsdale Investment Management, an independent, partner-owned and client-aligned investment boutique that manages more than $3.5 billion on behalf of a select group of sophisticated institutional and private wealth investors.