A handful of the largest stocks were the only game in town for much of last year, as a batch of tech titans raced ahead of the rest. But this seemingly relentless focus on the biggest players may have left their far smaller counterparts underappreciated. We’ve been exploring the investment opportunities among oft-overlooked small and mid-sized companies.

The context is that smaller stocks have trailed their larger peers for a while now. With some ups and downs along the way, the S&P 400 Mid Cap Index and S&P 600 Small Cap Index have underperformed the S&P 500 (which comprises only large stocks) by nearly 25% and 35%, respectively, since the start of 2017.

The underperformance of smaller stocks over that period hasn’t been driven by a clear difference in fundamental performance, as measured by earnings or sales. Instead, it has been caused by big changes in valuations — the multiples that investors are prepared to pay for every dollar of earnings. On most conventional measures of valuation (such as price relative to earnings, sales, cash flows or the book value of companies’ assets) large stocks have become much more expensive in that time, whereas in most cases the opposite has happened to smaller stocks.
 

The gap is now a gulf

As a result, what was a gap between the valuations of large and small stocks has turned into a gulf. The difference is now about as large as it was at the end of the dotcom era nearly a quarter of a century ago. (Our graph shows the US as an example, but the gap between the valuations of large and smaller stocks is very large by past standards in Europe too.)
 

Source: Refinitiv and Rathbones

That comparison is a particularly striking one because the dotcom bust subsequently proved a major turning point for the performance of smaller versus larger stocks. Smaller stocks had lagged for years in the tech boom of the 1990s, just as they have done recently. But the tide turned decisively around 2000. What followed was a decade of strong, sustained outperformance from smaller stocks.

Market history never repeats itself exactly, so we shouldn’t take the point too far. We don’t believe large technology companies have the markers of a classic financial bubble. But the size of the valuations gap today is still striking. It’s enough for us to conclude that a long-term investment opportunity may exist in smaller stocks. Evidence that the global economic cycle is picking up (discussed in our lead article in Investment Insights on page 4) also helps, as smaller stocks have historically been more economically sensitive. So does the fact that smaller stocks have kept pace with larger ones since the recent rally in markets began in late October. This is an improvement on their relative performance previously.
 

There’s no need to compromise

What about the common criticism that investing in smaller stocks means compromising on the quality of our holdings? (When we talk about quality in this context, we’re specifically referring to things like firms’ ability to service their debts, the size and stability of their margins and how efficiently they invest. We usually favour stocks with markers of high quality in our investments, reflecting the evidence that they tend to perform well through the ups and downs of the market cycle.)

It is certainly true that on average, smaller companies do score worse on these metrics than their larger counterparts. Academic work has also shown the significant difference that the inclusion of some very low-quality firms can make to the long-term returns from investing in smaller stocks.

However, the key thing to emphasise is we don’t have to accept the average. This is an area where an active approach — careful selection of funds and/or stocks — can pay off. We don’t need to simply buy the broadest indices of smaller stocks. Ample high-quality options exist among smaller companies, so it’s a question of avoiding the few highly indebted or unprofitable firms.

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