SMID-cap equities are poised to mean revert and outperform over the next three to five years. The best time to allocate to SMID caps is when earnings are “depressed”, i.e. now.

Key points

  • Global SMID caps have traditionally had higher growth rates and returns over the long term than large-cap companies, primarily due to the fact that they are in the “sweet spot” of their business cycle, meaning they show great potential for growth and earnings.

  • As the SMID-cap universe is under-covered by financials analysts, it can lead to market inefficiencies and attractive entry points for investors seeking exposure to “hidden gems” and innovative companies operating in diverse niche sectors.
  • Looking at diversification power, not only do SMID caps have the potential for strong growth, but they also have less valuation risk than their large-cap growth counterparts and less absolute risk than emerging market equities.

In recent weeks, investors were relieved by the positive newsflow around the successful COVID-19 vaccine trials and subsequent implementation of roll-out programmes. However, experts agree that the positive effects on the recovery and getting back to “normality” is not likely to happen before the end of this year. As 2021 looks like a bumpy road, many investors are willing to increase equity risk and directionality, subject to selectivity.

Against this backdrop, the wider small- and mid-cap (“SMID cap”) universe represents a fertile ground for investment opportunities and one of the last efficient frontiers for active equity investors to express their convictions. However, the high-potential SMID-cap segment requires proven active management skills to find the hidden gems of tomorrow and apply the necessary risk management rules. 

In this paper, we will take a closer look at the benefits of SMID caps and why they offer an attractive opportunity set in the current environment. We will also provide a roadmap to SMID-cap investing through various examples of UBP’s key capabilities in the SMID-cap space.

Why invest in SMID caps today?

A valuable risk-on option during bullish market trends, including post-crises 

Global SMID caps tend to outperform during bull markets. In the calendar years when the MSCI World Index performed well, i.e. 2006, 2009, 2010, 2012, 2013 and 2017, global SMID caps always outperformed. The only exception, although minimal, was the recent 2019–2020 period, which was more a function of large-cap growth driving markets.

Just as important, global SMID caps have also shown stronger rebounds after a major crisis, as was the case following the dot com bubble and the global financial crisis. As vaccine breakthroughs put COVID-19 protection within reach and offer a way out of the current crisis, it is likely that we will see a more pronounced rebound coming from global SMID caps than from the broader market or other equity segments.

An ideal entry point

While global SMID caps have outperformed the wider market over the long term, they have lagged behind in recent years.

Moreover, it was only recently that global SMID caps surpassed their previous highs seen in early 2020 and back in early 2018.

This recent underperformance has generated an attractive entry point into the space.

In view of the above, should investors be worried about this performance lag in recent years and consider it as a structural weakness of the SMID-cap segment? 

We actually think the opposite. First and foremost because the underperformance of global SMID caps vs. larger caps can be easily explained by the latter’s tech rally driven by a handful of major names. Moreover, we are convinced that one of the key strengths of SMID-cap companies lies in the fact that they are more closely tied into the real economy and represent a universe with less sector distortion than larger-cap indices. This explains the less pronounced recovery of global SMID caps since the March 2020 trough so far and paves the way for a stronger catch-up in the months to come.

In reality, this catch-up between SMID caps and broader equities is currently happening, as shown by the significant outperformance of the MSCI World SMID Index compared with the MSCI World Index during the last quarter of 2020.

Better earnings leverage and less valuation risk versus large-cap growth 

The chart below, which compares the P/E ratio of global SMID caps to that of large-cap growth, shows that SMID caps are currently much cheaper than their growth counterparts and that they are trading well below what the relationship between the two has averaged over the last ten years.

Against a backdrop of lowered earnings for 2020 (circa -50%), global SMID caps are currently offering relatively better earnings leverage and attractive valuations by trading at a much lower P/E ratio than large-cap growth stocks. 

By simply applying conservative EPS forecasts for 2021, 2022 and 2023 to the MSCI World SMID Cap’s current 12-month forward P/E ratio, this would translate into significant upside potential for the index.  

With the combination of corporate cost-cutting, COVID-19-related stimulus packages and the reopening of global economies, we are highly confident that this earnings rebound – even a very conservative one – should happen, given how highly distressed 2020 earnings have been for SMID stocks.