nOVEMBER 2019

Over the past 40 years, small- to mid-cap (SMID‑cap) stocks have outperformed small- and large-cap equities in both bull and bear markets.

 

ryan-smith-author-image

Ryan Smith, CFA
Client Portfolio Manager

A perennial challenge for investors seeking a diversified portfolio is finding the right balance between larger and smaller stocks. An answer to this dilemma may be found in a third equity category: small- to mid-cap stocks, represented by the Russell 2500™ Index.


Higher Returns in Bull and Bear Markets 

Over the past 40 years, SMID-cap stocks have outperformed small-cap stocks (represented by the Russell 2000® Index) and large-cap stocks (represented by the S&P 500® index) by a significant margin (Chart 1). A hypothetical $10,000 investment in SMID-cap stocks in January 1979 would have grown to $1.21 million by September 2019, outpacing the S&P 500 by 22% and the Russell 2000 by nearly 37%.



 

Chart 1: Growth of $10,000 Since 1979

SMID-chart-1

Source: Morningstar, as of 9/30/19

 

What is the Russell 2500?

The Russell 2500 is comprised of small- and mid-capitalization stocks. It represents the smallest 500 large-cap stocks from the Russell 1000® Index and all 2,000 small-cap stocks from the Russell 2000 Index. The Russell 2500 Index represents approximately 20% of the total U.S. market capitalization.

 

This outperformance has occurred in both bull and bear markets. A hypothetical $10,000 investment in SMID-cap stocks during the dot-com boom in January 1995 would have grown to $118,248 by September 2019, 12% more than the same investment in the S&P 500 and 28% more than the Russell 2000 (Chart 2).

 

Chart 2: Growth of $10,000 Since 1995

SMID-chart-2

Source: Morningstar,  as of 9/30/19

 

In 2000, the dot-com bubble burst and ushered in what’s known as the “lost decade” for the S&P 500. SMID-cap stocks showed their resiliency over the next 19 years by outperforming the S&P 500 by 39% and the Russell 2000 by 19% (Chart 3).

 

Chart 3: Growth of $10,000 Since 2000

SMID-chart-3

Source: Morningstar, as of 9/30/19

 

We believe two primary factors are responsible for SMID-cap’s consistent performance over the past four decades: less analyst coverage and a larger “runway” for growth.



Less Analyst Coverage 

The average mega-cap stock (market capitalization over $300 billion) has 23 analysts studying the company, publishing reports and making buy/sell recommendations (Chart 4). The analysts’ output rapidly disseminates throughout the market, making it difficult to capture excess return before the information is reflected in a stock’s price. 

 

Chart 4: Analyst Coverage

SMID-chart-4

Source: Barron's, as of 4/1/19

 

Mid-cap and small-cap stocks average only 12 and four analysts, respectively. Far fewer analysts translates into less frequently updated reports and buy/sell recommendations, and new information takes longer to saturate the market and be reflected in stock prices. Consequently, there is more potential return for fundamentally focused stock pickers who can identify relatively attractive, but lesser known, equities.


Longer Runway

The higher potential return driven by less analyst coverage is amplified by the longer runway (larger range of market capitalization) afforded to SMID-cap stocks than their small- or large-cap counterparts (Chart 5).

 

Chart 5: Longer Runway

SMID-chart-5

Source: FTSE Russell, as of 9/30/19

 

For example, if a small-cap portfolio manager identifies a stock with a $500-million market capitalization, she can typically hold that position until it grows to roughly $4 billion, eight times the original investment value. If a SMID-cap portfolio manager identifies that same position, she can ride that stock until it exceeds roughly $14 billion in market capitalization, 28 times the original investment value. The longer runway can serve to compensate portfolio managers who can identify quality stocks and have the discipline to hold them.


Buying Small- and Mid-Cap Stocks 

Adding a SMID-cap allocation to a portfolio may also help address challenges investors may have when buying small-cap stocks, one of the most constrained corners of the equity market.

SMID-cap stocks make up roughly 20% of the total U.S. market capitalization, about two times larger than the small-cap universe represented by the Russell 2000. Given the difficulty of identifying historically successful small-cap portfolio managers with capacity to accept new money, we believe it makes sense to focus on the larger universe represented by SMID-cap stocks. A SMID-cap portfolio manager is far more likely to accept additional assets than one who is strictly small-cap focused.

SMID-cap stocks may also address investors’ need for disciplined coverage across all six small- and mid-cap Morningstar Style Boxes (Chart 6). Some portfolios have three or fewer managers who each focus on only one of the six smaller boxes, leaving gaps in portfolio exposures that may significantly impact returns over time. We believe a core SMID-cap portfolio manager can provide coverage across the smaller six boxes and remain “style pure” by not drifting higher in cap size or edging toward growth stocks.

Why do small-cap portfolio managers hold on to a position beyond $4 billion?

At times, portfolio managers hold on to their favorite stocks well past the point the equities graduate from the Russell 2000. As a result, many of the top small-cap portfolio managers have an average capitalization closer to the Russell 2500, underscoring the appeal of investing in SMID-cap.

 

Chart 6: Morningstar Style BoxTM SMID Coverage

SMID-chart-6

 

This provides a practical solution to the challenge of allocating among smaller stocks. With the core allocation covered for the smaller boxes, investors can then select complementary managers to emphasize specific style boxes without leaving gaps in portfolio construction. The style-pure portfolio manager may also be the most effective way to access SMID-cap, as the less-saturated coverage and longer runway would tend to compensate good stock pickers more than those whose styles tend to drift toward value or growth.1



Our Takeaway

SMID-cap stocks have historically outperformed large- and small-cap equities for a variety of reasons. Less coverage means SMID-cap’s potentially fertile ground hasn’t been trampled on by teams of large-cap analysts whose information is quickly reflected in stock prices. SMID-cap’s wider range of market capitalization creates a longer runway than small-cap and large-cap equities, providing the opportunity for greater returns. And a core SMID-cap portfolio manager may provide coverage across the six small- and mid-cap Morningstar Style Boxes, potentially giving investors a better way to allocate to smaller stocks while avoiding unintended gaps. 


What You Can Do Next? 

Contact us for more information about Pacific Funds Small/Mid-Cap

 

Ryan Smith is client portfolio manager at Pacific Global Asset Management LLC, the asset management division of Pacific Life Insurance Company that sponsors Pacific Funds. Pacific Funds offers Pacific FundsSM Small/Mid-Cap. For more information, please visit pacificfunds.com.

 

Definitions 

The Russell 1000 Index measures the performance of 1,000 of the largest companies of the U.S. equity universe. The Russell 1000 is a subset of the Russell 3000 Index.

The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.

The S&P 500® index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.


 

The Morningstar Style Box is a nine-square grid that provides a graphical representation of the “investment style” of stocks and mutual funds. For stocks and stock funds, it classifies securities according to market capitalization (the vertical axis) and growth and value factors (the horizontal axis).

1The annual difference between value and growth has swung wildly since 1979 and has tended to favor value by a slight margin across all market capitalizations, but the past decade has strongly favored growth stocks.

About Principal Risks: All investing involves risk, including the possible loss of the principal amount invested. There is no guarantee that the Fund will achieve its investment goal. Equity securities tend to go up or down in value, sometimes rapidly and unpredictably. Small- and mid-capitalization companies may be more susceptible to liquidity risk and price volatility risk, and more vulnerable to economic, market and industry changes than larger, more established companies.

This commentary represents the views of the portfolio managers as of 11/15/19 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment.

Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Sector names in this commentary are provided by the Fund’s portfolio managers and could be different if provided by a third party.

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