The Argument for Selectivity in SMID
What happened last week?
- The S&P 500 rose by 0.48%
- The Dow Jones dropped by -0.3%
- The Nasdaq gained 1.60%
The September jobs report came in much stronger than expected with 336K newly minted jobs and 119K in combined upward revisions to the prior two months’ total.
The unemployment rate held steady at 3.8%. The news initially sent bond yields higher and stock prices lower. Stocks later advanced as the data also showed average hourly earnings moderating to 4.2% y/y.
3 Things to Know
A Case for Building Positions in US SMIDs
Depressed small cap valuations may provide an attractive entry point for core portfolios even when adjusted for today’s higher rate environment.
We suggest a focus on high quality small firms who have been left behind in the mega-cap surge, while avoiding low quality companies that are found in passive indices. While recent performance has favored investors with a hefty allocation to large caps, history shows that SMID has outperformed in most decades over the past century.
This has been particularly true for profitable small and mid-sized firms, which have outperformed large caps since 1994.
In today’s market environment where seven companies are responsible for nearly 100% of S&P 500 gains for 2023, managers focused on fundamental analysis are able to identify market inefficiencies in the small- and mid-cap spaces across both traditional and alternative asset classes.
After a challenging period for smaller shares in 2022 and much of this year, small- and mid-caps are now historically cheap relative to their larger firm peers.
Quality SMID indexes currently trade at a 30% multiple discount to the S&P 500. We believe this presents an attractive entry point for multi-year holding periods.
What does this mean for investors?
In our view, depressed small cap valuations may provide an attractive entry point for core portfolios even when adjusted for today’s higher rate environment. We suggest a focus on high quality small firms who have been left behind in the mega-cap surge, while avoiding low quality companies that are found in passive indices.
Multiple Ways to Manage SMIDs
While index investing is a fantastic portfolio management tool, it fails to capture the potential for an active manager to utilize their research capabilities to generate unique investment theses in a SMID environment where there are simply fewer eyes tracking the individual companies.
Active management is most valuable in areas of the market where dispersion is high. On an index level, dispersion measures the variability of returns for the component stocks.
Within US equities, dispersion among small- and mid-cap companies is persistently higher than for large caps. The current degree of uncertainty on the economy given higher interest rates has pushed recent dispersion to around the 75th percentile of monthly values for both small and mid-cap companies, whereas it is below the 50th percentile for large caps.
The Citi View: Build a Quality SMID Portfolio
We have seen outperformance from quality companies within SMID cap indices. But what is quality?
Within the indices, these are the companies that have the best rankings based on return on equity, earnings quality, and financial leverage ratios.
This provides a fertile backdrop to not only pick the winners, but short the losers. Focusing on volatile and less efficient part of the market like SMID cap companies provides the potential for long/short equity hedge funds to seek outperformance through stock picking.
Traditional managers must manage their portfolio quality via a long-only approach by overweighting quality companies and de-emphasizing lower quality firms.
We think investors must dig into the details to find well positioned managers that have a track record of stock selection and underwriting skills.
While valuations are not a great short-term tool, when coupled with our outlook for moderating inflation and an eventual Fed pivot next year, we suggest building positions in the asset class.
See our weekly CIO Strategy Bulletin for more details