Over the past three years, the stock price appreciation of large companies has outpaced that of small and medium-sized companies, with one seeing negative annual earnings and the other seeing growth.
Speaking at the Morningstar Investment Conference in Chicago last week, an asset manager who specializes in small-cap investment funds acknowledged that, as one panelist put it, stocks of large companies have “left small caps behind” in recent years.
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Innovation led by small-cap companies “hasn’t changed and will come back,” Lee said, noting that a rise in shares of IT company Supermicrocomputer Inc. has largely driven a small portion of the overall gains in the Russell 2000 Index this year. The index, a popular benchmark for small-cap investing, is up just 0.86% through July 1, compared with a 14.79% gain for the S&P 500 Index.
“And if they didn’t own that, a lot of small-cap managers would go bust,” Lee said. “When those companies do well and do well, they become household names. People feel comfortable with them. They see them as less risky than investing in small companies. Small companies will do well again. I’m not in the business of predicting when, down to the second, but for investors, small companies are an attractive place to be.”
Small caps are an important part of many client portfolios.
But the so-called “Magnificent Seven” stocks — Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla — have driven the S&P 500 and other large-cap indexes to much higher levels than small- and mid-cap indexes over the past three to five years. In the 36 months through July 1, the S&P Global Large Cap Index rose 4.47% annually, while the S&P Global Small Cap 600 fell 2.41%, a difference of 688 basis points. Between the Russell 2000 and the S&P 500 over the same period, the gap was even wider, at 1,134 basis points.
But small-cap managers aren’t likely to abandon this approach anytime soon. Lee’s firm targets “exceptional growth companies” with less than $500 million in operating revenue, and although his team’s portfolios are “generaly biased toward technology and healthcare,” he said, they are “value-focused across the board.”
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Peck noted “a lot of opportunities globally” across all sectors in the U.K., industrial and consumer-based industries in Japan, and industrial, consumer discretionary spending and regional banking in the U.S. “High-quality” regional banks with strong underwriting track records and “prudent capital management” have value-based appeal.
The San Jose team is evaluating the management practices and business models of companies that could potentially invest in the fund, he noted. Construction-related products hold promise for investors, he said, especially as interest rates could move a little lower.
“High quality is really what we care about,” San Jose said. “Just looking at valuations, some of the banks look attractive.”
Moderator: Tony Thomas, Associate Director of Equity Strategies
“They have competitive advantages — their size, their scale, their resources,” he said. “What is the competitive environment for small and mid-cap companies? How have those competitive advantages changed over time?”
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Peck acknowledged that smaller businesses generally face “tougher” challenges, but he said that doesn’t mean there aren’t worthwhile investments in the asset class.
“We try to find, and we do find, a lot of companies that are adaptable and resilient and can compete with the bigger players, or find small niches that are doing very well,” she said. “They’re in markets that are too small for the bigger companies to be interested in. There’s no shortage of ideas or opportunities in any sector.”
His team of active managers in San Jose is “hunting down companies” that are boosting profit margins by 30, 50 or even 100 basis points a year, he said. “There’s opportunity in small caps. You just have to find it in these different niches.”
Lee said bluntly that Thomas’ Morningstar colleagues were simply wrong to ask for the 2% quota: “I think they should look for another job,” he said.
