Global Small- and Midcaps: Why Now?

 

Is now a good time to make an investment?

Nick Paul:

I actually think now's an excellent time to make an investment in global small- and midcap stocks. What's interesting is if you went back over time, over the very long term, I think we all know that global small- and midcap stocks have outperformed large caps over the very long term, but that relative performance will ebb and flow over time. However, there was a period back in the early 2000s, from, call it, 2000 up until 2008, so it's, think, post-dot-com era up until the global financial crisis, where you witness a sustained period of outperformance for global and small midcaps versus their large cap counterparts.

Now, are there analogies that you can draw between that period back in the early 2000s and where we are today? I think there's several. The first is just the inflationary and interest rate environment. That was an environment where, on average, 10-year treasuries averaged about 4.7% over that entire period. It was also an environment where inflation over that period, global inflation, averaged about 3.7%. It kind of feels little bit like where we are today, very different than a zero inflation, zero interest rate environment like we experienced the last decade.

So some inflation, some elevated interest rates is actually a bit more of a healthy environment for global small- and midcap stocks. They tend to be a more cyclical asset class, and that inflation and that interest rates in a lot of cases, if it's managed, can actually be quite a healthy environment for those types of businesses. So you have the interest rate, an inflationary environment that lines up with that period from 2000 to 2008. Valuation. You'd actually have to go back to the start of the early 2000s, just post the dot-com era, to find valuations as attractive as they are today. Today, valuations in small- and midcap, relative to large, are about two standard deviations cheap. So that's another similarity.

What's the third? The third similarity is really around concentrated large-cap benchmarks, primarily in technology companies. Again, sounds pretty familiar to where we are in today's market environment. So when that bubble burst back in the early 2000s, small- and midcap stocks strongly outperformed their large-cap counterparts. So as I think you start to look across those three dimensions, the period, again sort of post-dot-com up until global financial crisis, sort of lines up with where we are today.

And you actually started to see that play out even just a couple of years ago. So if you think back to October of 2022, so this was just following the initial rate hikes in early 2022, which obviously had significant downward pressure on markets, in October of 2022, as the market has started to digest a bit higher inflation and higher interest rates, there was actually a period where small- and midcap stocks started to strongly outperform large cap. So from October of 2022 through the end of February of 2023, small and mid was outperforming large by roughly about 400 basis points. And then all of a sudden, generative AI swept in and saved the day once again for mega-cap technology companies. But I think if it wasn't for that, which is a big if, things would look quite a bit different today. And I think that that's the trend that's likely to continue once this euphoria around everything generative AI and mega cap tech starts to subside, which I think it will.

 

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