Giant US tech equities have led the way over much of the last year. That’s left them looking expensive compared to small- and mid-cap shares, which have tended to perform better over time.
Global markets have been gripped in a repricing of the US growth outlook, forcing up long-term interest rates and the US dollar, steepening the yield curve. In the process equities have weakened across the board.
After a concentrated 2023 rally in certain large-cap S&P 500 companies, high quality companies with small and medium sized capitalizations (SMID) currently trade at a 30% discount to the S&P 500. When coupled with our outlook for moderating inflation and an eventual Fed pivot next year, it may make sense to build positions early.
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.
With a lack of buy- and sell-side analyst coverage in SMID, active management can be valuable in areas of the market where the variability of individual stock returns is high, and quality portfolios can be built using fundamental analysis.
Historically, not only have quality SMID companies outperformed the broader market, but companies that are of the lowest quality have lagged the broader market.
Beyond long-only managers, hedge funds may utilize a long-short SMID strategy to seek equity returns with low beta, volatility, and reduced drawdowns during periods of market stress. Strategies employed include investing in companies with strong fundamentals while shorting the lower quality end of the market.