Bucking The Trend: Why SMID Caps Are Poised For A Comeback

Originally posted on June 06, 2023

The recent performance of small- and mid-cap stocks, often referred to as "SMID caps”, and why they might be poised for a comeback has become a topic of interest among investors. SMID cap equities, which have traditionally been seen as more volatile and riskier than their large-cap counterparts, have recently underperformed both large-caps and the broad US equity market. This is mostly due to the uncertainty surrounding an economic slowdown and the looming threat of a recession that typically has a greater impact on the performance of smaller companies.

However, taking a closer look, we find that the current valuation of these smaller-cap stocks is becoming increasingly attractive relative to large-caps. This combined with an economic recovery phase possibly on the horizon, where smaller-caps have historically outperformed, supports the case that now may be a good opportunity for investors to allocate to this area of the market.

Performance Leading into a Recession

Historically, small- and mid-cap stocks have shown a tendency to underperform large-cap stocks in the period leading up to a recession. This is primarily due to their higher risk profile and greater sensitivity to economic conditions. As uncertainty increases and economic indicators point towards a slowdown, investors often shift their portfolios towards more stable, large-cap companies, which are generally considered safer during turbulent times.

For example, small- and mid-caps, represented by the Russell 2500 Index, have underperformed the S&P 500 during the 12 months preceding recent recessions. On average, the SMID caps underperformed by nearly 700 basis points during these periods. This underperformance of smaller companies can be attributed to their higher volatility and the fact that they are often more exposed to domestic economic conditions. While we are not officially in a recession today, smaller companies have been punished as if we are heading in that direction. As of the end of May, SMID caps have underperformed the S&P 500 by about 700 basis points over the last year.

SMID Cap Underperformance Preceding Recessions

Dominate Performance Following Recessions

While small- and mid-cap stocks often bear the brunt of a recession, they also tend to bounce back strongly during the recovery phase. Historically, smaller companies have outperformed their larger counterparts 83% of the time in recoveries and saw average annualized returns of 26% during the recovery phase.¹ This is because smaller companies tend to benefit more from fiscal stimulus measures and are often more leveraged to the domestic economy, which usually recovers before the global economy. They are also generally more agile and can adapt more quickly to changing economic conditions.

This outperformance of smaller companies during the recovery phase can also be observed by looking at recent recession cycles. On average, the SMID cap Russell 2500 Index outperformed the S&P 500 by roughly 1000 basis points in the 12 months following the end of recent recessions. Furthermore, data shows that this outperformance extends beyond just the first year. Increasing to five-year post-recession periods, the average annualized return for smaller-cap companies was 14.5% compared to an annualized return of about 12% for large-caps.²

SMID Cap Excess Return over S&P 500 Post Recent Recessions

The Current Opportunity – Decade Low Valuations Ahead of a Possible Recovery

Given the recent underperformance of smaller market-cap US equities and the looming threat of an economic slowdown, it might seem counterintuitive to consider allocating to small-caps. However, it's important to remember that markets are forward-looking, and much of the anticipated economic slowdown may already be priced into this segment of the market.

Currently, valuations for SMID cap companies look extremely attractive relative to large-caps, the most attractive in decades actually. As of the end of April, the forward price-to-earnings (P/E) ratio for SMID cap companies are now at 20-year lows relative to large caps. This relative undervaluation could provide a good entry point for investors considering an allocation to smaller cap companies. While the threat of an economic slowdown or recession is still present, the potential upside of these already beaten down stocks in a recovery could be worth the risks.

SMID Cap Forward P/E Relative to Large Cap Forward P/E

January 2004 – April 2023

The VanEck Morningstar SMID Moat ETF

While the uncertainty of an economic slowdown and possible recession has led to the underperformance of small- and mid-cap US equities recently, their current decade low valuation relative to large-caps and historical outperformance in economic recoveries presents a potentially attractive opportunity for investors.

Given the current economic climate, it may now be an opportune time to consider diversifying your portfolio with SMID cap equities. As we continue to navigate an economic slowdown, or potential recession, and the subsequent recovery, SMID caps may offer a compelling investment opportunity for those looking to capitalize on their historical potential for outperformance on the back side of economic turbulence.

For investors looking to gain exposure to smaller-cap equities, the VanEck Morningstar SMID Moat ETF (SMOT) could be an attractive option. SMOT seeks to track the Morningstar^® US Small-Mid Cap Moat Focus Index^SM, which leverages Morningstar’s forward-looking, rigorous research process, driven by over 100 analysts globally. The Index applies much of the same core index methodology principles as Morningstar’s flagship Wide Moat Focus Index, but to a universe of small- and mid-cap companies. The Index targets SMID cap companies with long-term competitive advantages, known as moats, and attractive valuations.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.