Patrick Quinn argues for specific small and mid-cap mandates - and active management - as attractive risks at this point in the economic cycle
Small-cap stocks have out-performed their large-cap counterparts in the US by 200 basis points (bps) per year since 1926. We will discuss the advantages of adding a strategic allocation of mid-cap equities to the well-documented case for small-cap stocks. From a more tactical standpoint, we will put the current environment in context as it relates to the prospects of small and mid-cap relative returns. Finally, we’ll discuss why it is prudent to utilise active management to maximise the return potential of the inefficient small and mid-cap asset class.
The widely accepted total US equity benchmark, the Russell 3000 index, can be divided into three discrete size segments. First, the Russell Top 200 index (roughly 200 large-cap stocks, 67% of total US market cap), then the Russell Midcap index (roughly 800 stocks, 25% of total US market cap), and finally the Russell 2000 index (roughly 2000 small caps, 8% of total US market cap). The widely accepted small/mid-cap benchmark, the Russell 2500 index, is comprised of the Russell 2000 Index plus the 500 smallest stocks of the 800 in the Russell Midcap index.
Since the inception of the Russell indices in 1979, the Russell 2500 index has outpaced the Russell Top 200 Index by 163bps per year. The risk-adjusted returns are superior for small/mid- caps too, with a Sharpe ratio since inception of 0.35 versus 0.32 for the large cap index. We believe the small/mid-cap advantage in benchmark returns (even before considering the return premium of active management) is primarily a function of higher earnings and cash flow growth - the true long-run driver of stock prices.
While many institutional investors utilise a separate allocation for small caps, most do not have the proper exposure to mid caps. This is because many investors incorporate their mid-cap exposure with their large-cap mandate, often benchmarked to the Russell 1000 (which includes both the Russell Top 200 and Russell Midcap indices). But because 73% of the Russell 1000 is comprised of the largest 200 stocks, large-cap managers focus their research time, and portfolio weight, on this relatively efficient segment of the market. According to the eVestment Alliance database, US large-cap portfolios are 6% underweight the smaller end of the Russell 1000. Therefore, utilising a large-cap mandate to gain exposure to the mid-cap asset class typically results in a strategic underweight to mid caps - a sub-optimal solution, since a strong case can be made for a strategic overweight due to mid caps’ higher absolute and risk-adjusted returns. And this doesn’t even consider the lost alpha opportunity by using managers who are not focused on the small and mid-cap area.
Moving from a strategic discussion to a more tactical one, let us discuss smaller-cap equities in the current environment. To gauge investor risk appetite for size during and after recessions, we analysed relative performance around the last 12 recessions. Small caps consistently underperformed large caps (-11.6% versus -7.4%) during the first half of recessions and outperformed during the second half (18.8% versus 15.0%). Even more importantly, given where we are in the current economic cycle, the small-cap outperformance persisted in the year following the end of recessions. Only once in the last 12 recessions has this not been the case. The data also suggest that in year two following the end of a recession, there is virtually no return differential, on average, among the size segments. Rather, at that point in the cycle, relative performance comes down to fundamentals and valuation.
Some talk about the direction of the US dollar, the interest rate environment, and market direction as drivers of smaller cap relative performance, but an analysis of past cycles suggests there is little correlation. The data suggest that small versus large-cap performance cycles have been driven by extremes in relative valuation or extremes in fear and risk aversion. The latter would favour smaller-cap equities currently. From a valuation standpoint, current relative valuations are in line with long-term averages, giving no advantage to any size segment. Therefore, fundamentals are most likely to dictate small/mid cap relative performance beyond year-one post this recession.
Small and mid-cap companies have better growth profiles than large companies and are less dependent on overall economic growth to fuel earnings. They are essentially the ‘market share gainers’ which are less dependent on the overall end-market growth that large companies require. The risk to small and mid-cap stock prices (as opposed to company fundamentals) is a resurgence of broad-based fear and liquidity concerns.However, we believe the US has passed the economic ‘Armageddon’ scenario. Even if the US is due for a period of subdued economic growth, small and mid-cap stocks could perform well. Take two of the more lacklustre periods of economic growth over the last several decades, July 1973 to December 1975 and January 1979 to March 1983. The cumulative real GDP growth during the first period was 0.9% and small caps outperformed large caps 34.3% versus 17.6% per year. In the second period, cumulative GDP growth was 2.2% and small caps outperformed large 6.6% versus -1.6% per year.
We also believe there are substantial opportunities for small/mid-cap active managers. That small and mid-cap equities have less Wall Street coverage, greater earnings forecast dispersion and higher average earnings surprises is well documented. Lower trading volumes in small and mid caps create volatility, on which well-resourced active managers can capitalise on their deep company knowledge and valuation analysis. Also, active managers can reduce the overall volatility seen in benchmark returns by avoiding the most risky businesses and focusing on those that are less economically dependent and those that have open-ended growth opportunities within the vast universe of small and mid-cap companies.
From a quantitative standpoint, there has been much research documenting the alpha potential in the small-cap space. In particular, a 2005 article in the Journal of Portfolio Management by Gregory Allen of Callan Associates asserts that the average alpha over the past 20 years is over 500bps annually. There is limited survivorship bias in his data, but Allen admits there is perhaps 100bps of instant history bias. Even after compensating for this, the data suggest significant opportunity for active managers to add value in smaller-cap equities.
Small and mid-cap stocks have produced superior returns over long periods of time. We believe this is likely to continue as we exit this recession, but also longer term, given superior fundamental characteristics and relative valuations that today are in line with long-term averages. Finally, with a strong case for both a strategic and tactical allocation to small and mid-cap equities, utilising active management within the asset class is the most effective way to maximise its return potential.
Patrick Quinn is US equity specialist at William Blair & Co