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March 2024
Exploring Opportunities for Global Small- and Mid-Cap Stocks in the Next Cycle
The global small- and mid-cap asset class has strongly outperformed large-cap stocks over the long term (Exhibit 1), and while market leadership ebbs and flows over shorter periods of time (Exhibit 2), we feel the asset class appears well-positioned to potentially assume a leadership role in the next rotation.
In our view, the opportunity set for small- and mid-caps appears particularly attractive. Referring back to Exhibit 2, from end of the dot-com-era (early 2000s) up until the early days of the global financial crisis (GFC) (2008), global small- and mid-cap stocks significantly outperformed relative to their large-cap counterparts with the MSCI ACWI SMID Index returning 94% vs. the MSCI ACWI Large Cap Index return of just 21%. While no two periods are perfectly alike and past performance is no guarantee of future results, one could draw a number of similarities between that roughly eight-year period from the early to late 2000s to today’s environment. First, and importantly, valuations potentially offer investors a buying opportunity not seen in decades (Exhibit 3), as valuations are close to two standard deviations “cheap” relative to large caps.
Next, inflation and interest rates during the run up to the GFC are more aligned with today’s reality versus what we witnessed in the decade following the GFC to the culmination of the COVID Pandemic. At that time, inflation was essentially non-existent and global yields were either close to zero or even in negative territory. In fact, from 2000 through the end of 2007, the 10-year US Treasury yield averaged 4.7% and global inflation averaged 3.7% (Exhibit 4). That period is not all that different from today.
Markets during the pre-GFC period also witnessed a dramatic sell-off as the dot.com bubble burst. The high-flying technology stocks with unattainable growth expectations — think irrational exuberance — of that period are rather analogous to the meme stocks of today. Looking at the concentration of the Russell 1000 Growth Index at the end of 2001, similarities are again quite apparent post-Covid (Exhibit 5).
In addition to the similarities we can draw to the past, we feel future spending trends may benefit a wider cohort of sectors and industries, including small- and mid-cap stocks, rather than just the mega-cap technology companies that garnered the dominant share of spending in the past decade. Specific to small- and mid-cap stocks, spending trends may be driven by a 70-year high in the average age of fixed assets as sales have benefitted during past capex cycles (Exhibit 6). Further, a move to localization as governments and companies around the world onshore supply chains to improve their supply chain resilience could provide a tail-wind to the small- and mid-cap asset class. We believe the local nature of small- and mid-cap companies could work in their favor while large-cap company margins may come under pressure as benefits of globalization (lower taxes and labor costs) subside as onshoring gears up.
With all of that said, we believe the biggest reason to consider a dedicated allocation for suitable investors to the global small- and mid-cap asset class today is that global investors are significantly less able to gain exposure to small- and mid-cap stocks through the traditional standard global benchmark allocation. This is primarily due to the strong performance of a handful of US technology stocks during the past decade (and their ensuing increase in market capitalization). In our view, the dominance of the most influential large-cap stocks can be better appreciated when viewed from the perspective of market-capitalization buckets, as illustrated in Exhibit 7, where exposure to small- and mid-cap stocks in the MSCI All Country World Index has declined from 45% in 2010 to only 21% at the end of 2023, as the weighted average market cap of that index has gone from $66B to an astounding $468B over that same period. It is worth noting where this percentage change was reallocated: stocks with a market capitalization of greater than $300 billion in the index increased significantly.
We believe this asset class may present more alpha opportunity for active managers. The universe receives substantially less research coverage by sell-side analysts compared to other asset classes, particularly large-cap stocks (Exhibit 8). The return dispersion for small- and mid-cap stocks is more than double that of large-caps (Exhibit 9). We feel both of these factors present ample opportunity for active managers with the experience and deep research resources to identify attractive stock opportunities.
With our nine investment research offices around the globe and our collaborative global research platform, we can place analysts in local markets, where they perform in-depth company research and cross-border comparisons on a stock-by-stock basis. We believe the breadth and depth of our platform allows us to cover and uncover stocks that others may miss, and we strive to deliver a well-diversified global small- and mid-cap portfolio.
All told, MFS has:
The information included above as well as individual companies and/or securities mentioned should not be construed as investment advice, a recommendation to buy or sell or an indication of trading intent on behalf of any MFS product.
Important Risk Considerations:
Stock: Stock markets and investments in individual stocks are volatile and can decline significantly in response to or investor perception of, issuer, market, economic, industry, political, regulatory, geopolitical, environmental, public health, and other conditions.
International: Investments in foreign markets can involve greater risk and volatility than U.S. investments because of adverse market, currency, economic, industry, political, regulatory, geopolitical, or other conditions.
Mid-cap: Investments in mid-cap companies can be more volatile than investments in larger companies.
Small-cap: Investments in small-cap companies can be more volatile than investments in larger companies.
Index data source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.
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The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice. No forecasts can be guaranteed.