06 May 2016
Indeed, over the long term, except during periods of economic downturn, small and mid-cap (SMID) stocks consistently outperform large caps.
Consider that, from December 31, 1999-December 31, 2015, the MSCI Europe Small Cap Index generated a total return of 292%. Over the same period, the MSCI Europe Index generated a total return of just 53%.
Taking an even longer view from the other side of the Atlantic, $10,000 invested in US small-cap stocks in 1926 would have been worth a staggering $266 million in 2014 – compared to less than $50 million if the same initial investment had been made in large caps.
So what explains this historical outperformance?
First, the very essence of small and mid caps: given the size of such firms, they are able to react quickly to market trends. Typically founded by one person or a small group of like-minded individuals with an idea for a new product or service, SMIDs are also inherently focused on innovation – and profit from that dynamic, entrepreneurial spirit.
Given that such firms often find accessing capital very difficult, founders are typically primary investors, with their own money on the line and, accordingly, uniquely high levels of management commitment.
As such companies cannot seek to compete in market segments dominated by giants that benefit from economies of scale, SMIDs tend to focus on a niche, where structural opportunities support sustainable growth. Think of Chobani – founded in 2005 by a Turkish immigrant eager to introduce Americans to yogurt that tasted like home – today valued at some $3 billion.
By concentrating on a niche product or service, SMIDs can remain in very close contact with suppliers and clients: Chobani’s founder located his first factory adjacent to a dairy farm, picked up a secondhand yogurt separator for just $50,000 and gave supermarkets free yogurt in exchange for the shelf space he otherwise could not afford.
As SMIDs start from a lower base than large caps, they can grow faster. And with leaner and more flexible cost structures – supported by efficient decision-making – SMIDs can typically better manage earnings.
In percentage terms, SMIDs reinvest more than large caps in future growth, partly because dividend distribution is normally limited. They also tend to have low debt-to-equity ratios, reflecting typically conservative borrowing strategies.
The lack of significant analyst coverage of SMIDs can make it difficult to attract external investment, and also creates plenty of market inefficiency. Given that investment banks are actively reducing their coverage of SMIDs – as part of a broader effort to reduce costs – such inefficiency will only increase.
It is therefore safe to assume that the share price of many of the more than 1,000 European SMIDs does not reflect fair value. And therein lies a mostly untapped opportunity.
Against the current backdrop of economic recovery, we expect SMIDs to continue to outperform, further supported by an interest rate environment that has reduced the cost of borrowing and accelerated M&A trends – making SMIDs especially attractive takeover targets.
There are, of course, risks associated with investing in companies with limited track records and minimal analyst coverage. Market volatility and macroeconomic uncertainty further cloud this picture.
Not every SMID will prove as successful as Chobani, which reached $1 billion in annual revenues five years after launch. However, over the long term, small and mid-cap stocks have clearly demonstrated their potential to deliver superior returns.