Why investors should look beyond headline large caps

This article is part of
Guide to finding value in US equities

Why investors should look beyond headline large caps
(LUIS ROBAYO/AFP via Getty Images)

When it comes to large-cap US stocks, the likes of Colgate-Palmolive, Electronic Arts and Mondelez – or at least their products – are likely to be well known around the world.

Indeed, headlines on the US equity market often focus on its behemoths, says Andrew Holliman, lead manager of the Polar Capital North American Fund. “That is because a huge number of large blue-chip, world-beating companies are located in the US. It also might be because for most of the past decade, large caps in the US significantly outperformed small and mid-caps.”

But Holliman adds that a “forgotten quality” of the US market is the breadth and depth of some of its smaller companies. “[These] either become large caps or carry on compounding away for a long time without becoming particularly large. 

“Over the long term, small and mid-caps have outperformed broader indices in the US and the outperformance of large caps versus small and mid-caps over the past decade is more a case of the exception than the norm.”

VT Tyndall North American Fund manager Felix Wintle agrees that small caps can be overlooked. “It’s easy sometimes to forget that the winners of today started life as small companies then grew to become much larger. As the cycle turns, investors should look to new companies as leadership, as these companies will deliver the innovation that drives the next cycle.”

The case for small and mid-caps

“Historically, smaller companies within the US have accounted for a lot of the innovation we’ve seen in the economy,” says Eric Papesh, a portfolio specialist in T Rowe Price’s US equity division. “Returns from the small and mid-cap market have dominated what we’ve seen from the large-cap segment over the long term.

“Adding a modest allocation of small-mid cap US equities to a balanced portfolio not only enhances returns, but it also improves the portfolio’s risk-adjusted performance given that the asset class is less correlated with other segments of global equity markets.”

Ralph Bassett, head of North American equities at abrdn, says he has been more positive on smaller companies for the past few months. “[It] isn’t typically what one may expect, as often defensive positioning would lead to a preference for larger companies. Our conviction here is rooted in valuations, which sit at historically wide margins to peers, but increasingly look attractive on an absolute basis.

“Importantly, we think that in certain cases, the expectation that earnings will come down is already reflected in the share price of smaller companies, and crucially that they will have the agility to navigate out of a recession more quickly than their large-cap peers.”

Matthew Miskin, co-chief investment strategist at John Hancock Investment Management, says mid-caps have seen some of the strongest earnings growth across capitalisation within the US equity market.

“We see mid-caps as a compelling, often overlooked part of the US equity market. They can be companies that are growing their way up into large-caps or, said another way, they can be the large-caps of the future.