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Market View

Some may think of this strategic combination of small- and mid-cap stocks as a way to participate in U.S.-focused companies—but it has other potential advantages.

Recent headlines about the United Kingdom’s prospect of a “hard Brexit” (regarding its decision to leave the European Union), given the contentious rhetoric from U.K. and EU leaders, have revived investor concerns about the global economy. That’s why in an earlier Market View we spotlighted a strategy of potential interest to investors who would prefer to take a more U.S.-focused approach: a so-called “smid-cap” strategy, which combines U.S. small- and mid-cap stocks. We noted in the earlier piece that companies in those two categories derive a higher percentage of revenues from the United States than their large-cap counterparts. Forecasts for slow and steady growth for the U.S. economy stand in better contrast to the unsettled picture for other developed and global economies.

Beyond their U.S. focus, however, we believe there are additional reasons to consider smid-caps. In this Market View, we’ll spotlight three of them.

1. A Record of Historical Outperformance

We’ve made this point before, but it bears repeating: the stocks of U.S. mid- and small-sized companies consistently outperformed over longer time periods. As Table 1 illustrates, when looking at trailing 10-year periods, small and mid caps have occupied the top two slots on the equity-style leaderboard for a large majority of the past 10 years.

 

Table 1: Mid and Small Caps Have an Historical Record of Long-Term Outperformance
Equity 10-year rolling returns by style for 2005–15

Source: Zephyr and Bloomberg.
1Russell 2000® Index. 2Russell Midcap® Index. 3Russell Top 200® Index. 4S&P 500® Index.   
Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results. Performance during other time periods may have been different or negative.
The historical data shown in the chart are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Small cap and mid cap company stocks tend to be more volatile and can be less liquid than large cap company stocks. Due to market volatility, the market may not perform in a similar manner in the future.

 

And based on year-to-date return data from Bloomberg for 2016 (through October 5), the trend has largely continued, with both small and mid caps posting strong performances in the aftermath of early-year market volatility. (The February 22nd Market View spotlighted the appeal of smid caps in the aftermath of the January–February market downturn.) 

2. An Underfollowed and Under-Owned Asset Class

U.S. small- and mid-cap stocks represent an underfollowed, and under-owned, area of the market, potentially creating an opportunity for long-term investors. Stocks in these asset classes typically receive less attention from Wall Street analysts than their large-cap counterparts.  For example, a 2015 research report found that around 20% of small-cap stocks do not have any coverage from brokerage firms, “which would be unthinkable in large- or mega-cap equities.”1 The relative lack of research on small-cap companies may lead many market participants to exclude them from consideration as investments. That, in turn, may present opportunities for active managers with experience in evaluating lesser-known small-cap equities.

As for mid caps, an industry researcher recently noted that the asset class “tend[s] to be overlooked,” as most media attention is focused on large-cap stocks.2 “The tendency to give mid caps short shrift leads to mis-pricing of the stocks, and that creates opportunities for bigger gains,” the researcher added.

Small- and mid-caps also appear to receive less attention from retail investors, who typically place a greater focus on the large-cap segment of the market. (See Chart 1.) While small and mid caps comprise 35% of U.S. equity market capitalization, they represent only 23% of U.S. equity mutual fund assets.

 

Chart 1Investors Are Underexposed to Small and Mid Caps
Share of the U.S. equity market and U.S. equity mutual fund assets under management by market-cap category, as of June 30, 2016

1Source: Bloomberg. Market cap of Russell Top 200® Index (Large Cap), Russell Midcap® Index (Mid Cap), and Russell 2000® Index (Small Cap). 2Source: Simfund. This depicts Morningstar categories.
AUM=Assets under management.
Past performance is no guarantee of future results. The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Small cap and mid cap company stocks tend to be more volatile and can be less liquid than large cap company stocks.

 

What implications does this have for the smid-cap investor? The fact that small- and mid-cap stocks often fly under the market radar may provide an opportunity for active managers to identify the market inefficiencies that can help them identify attractively valued stocks in those categories.

3. Diversification and the Potential for Reduced Volatility

As we have noted in earlier Market Views, small- and mid-cap stocks generally are added to portfolios to enhance returns and diversify large-cap equity allocations. To be sure, the two categories do have well-noted risks. Smaller companies typically involve greater risks from fluctuations in business conditions and illiquidity in stock trading than larger firms. Also, smaller companies have more limited product lines, market exposure, or financial resources than large-cap companies.

But combining the available pool of U.S. small- and mid-cap companies results in a larger investment universe, enhancing the opportunity for portfolio diversification. Diversification across these different styles may provide better downside protection in volatile markets than might each style independently.

Here’s how that might work:  Investors should note that, in any given year, returns will fluctuate across these small- and mid-cap strategies. However, using a smid-cap strategy, whereby mid-cap stocks are paired with small caps, results in a stronger risk/reward profile than small caps alone, and may reduce volatility. As Chart 2 illustrates, smid-cap strategies offered higher returns than small caps over a 20-year period, with lower volatility (as measured by standard deviation). This is especially relevant for investors who are weighing an increased allocation to small caps in their portfolio—a smid-cap strategy potentially could harness the return potential of small caps, while mitigating their characteristic volatility.

 

Chart 2. Compared to Small Caps, a Smid-Cap Strategy Historically Has Provided Higher Return with Less Volatility
Total return and standard deviation for the indicated categories, October 1, 1996–September 30, 2016

Source: Russell Investment and Zephyr Style Advisor. Small caps are measured by the Russell 2000® Index. The smid-cap strategy is represented by the Russell 2500 Index.
Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results.
The historical data shown in the chart are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Due to market volatility, the market may not perform in a similar manner in the future. Small cap and mid cap company stocks tend to be more volatile and can be less liquid than large cap company stocks.

 

In closing, let’s revisit the diversification theme. A smid-cap strategy, by its very nature, is a broad-based investment approach that straddles style borders, combining investments in small- and mid-sized capitalization companies and often selecting from within that universe a combination of value, core, and even growth stocks. In drawing from the growth, value, and blend categories with small- and mid-cap stocks, a smid-cap strategy focuses on the equity styles that consistently ranked at the top of long-term returns. Think of it as a way to check a number of key style boxes through a single strategy. 

 

1”Small Caps, Large Opportunity,” Lazard Asset Management, February 12, 2015.
2Steven Goldberg, “Mid-Cap Stocks Are the Market's Sweet Spot,” Kiplinger.com, September 21, 2016.

 

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INVESTING THE SMID WAY
The Lord Abbett Value Opportunities Fund seeks to deliver long-term growth of capital by investing primarily in stocks of small & mid-sized U.S. companies.

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