Strategy

US Small And Mid-Caps To Outperform In 2023 – Schroders

Amanda Cheesley Deputy Editor January 2, 2023

US Small And Mid-Caps To Outperform In 2023 – Schroders

Bob Kaynor, head of US small and mid-cap equities at asset manager Schroders, discusses whether the outperformance of US small and mid-caps can continue in 2023.

Although large caps outperformed strongly in January 2022, since then small and mid-caps have been steadily outperforming, Bob Kaynor at Schroders said in a recent statement.

“In theory, this is at odds with a US economy that is expected to slow down into a possible recession in 2023,” he continued. “Normally small and mid-caps are considered less resilient in a more challenging economic environment. There are reasons [why] this leadership change is taking place and it is reminiscent of a similar time which led to an extended period of outperformance by small and mid-caps,” he said.

Both in the 1970s and after the bursting of the technology bubble in 2000, US smaller companies performed much better than larger companies for a number of years, Kaynor added.

“This outperformance from smaller companies occurred when the Federal Reserve funds rates and economic growth were both rising and falling. This consistent outperformance through a variety of different economic environments occurred from a similar starting point: superior earnings growth coupled with low valuations relative to their large cap brethren. Past performance is no guide to the future, of course, but we see many similarities with the current environment,” he said.

“A good starting point to support US smaller companies is that today’s valuations are already pricing in a lot of bad news. The universe is not dominated, for example, by secular growth companies like the large-cap S&P 500 is. This means there is very little valuation premium that needs to unwind to adjust to a changing world economy,” he continued.

Smaller companies have not been as cheap relative to large caps since the technology bubble in 1999 to 2001, he added. In the seven-year period following the market peak in March 2000, small caps were up by more than 70 per cent whereas large caps were up by less than 10 per cent.

“The last time relative valuations were this cheap, and sentiment so poor, was followed by an outstanding period of absolute and relative returns for small and mid-cap equities,” Kaynor said.

Small caps better positioned to benefit from changing consumer trends
Depressed valuations are only one aspect of the favorable outlook for the asset class. “Smaller, more domestically-oriented companies in the US are better positioned to benefit from changing trends in the US economy,” he continued. 

Although the US consumer remains resilient, consumer spending is changing from goods to services. The goods economy remained robust during the Covid-19 pandemic, while the services economy remained closed. Smaller company earnings are much more geared to services, which should further fuel favorable relative earnings growth, he added.

“Another trend that was evident before the Covid-19 crisis, but has since accelerated, is the rise in capital spending in the US. There is a major initiative underway to re-shore supply chains as globalization starts to retreat,” he said.

The US government is also providing major incentives to promote more domestic manufacturing, enshrined in legislation through policies such as the CHIPS and Science Act and Inflation Reduction Act passed in 2022. The Infrastructure Bill of 2021 provides additional tailwinds, Kaynor continued.

Other factors supporting capex are efforts to reduce emissions and the need to spend on automation in order to mitigate labor shortages. Sales growth of smaller companies is highly correlated to US capex growth. This reflects the largely domestic focus of small cap businesses compared with large caps. This domestic exposure also insulates companies from translating non-US returns into US dollars, he added.

Time to broaden out portfolio allocations
“Retaining exposure to US equities remains an important allocation in a diversified investment portfolio but there are reasons to reconsider allocations across the asset class,” he said. 

Over much of the last decade, investing exclusively in the S&P 500 would have been the best decision. However, change is now underway. “There are now good reasons for investors to broaden their allocations into mid- and small-cap US companies that are more attractively valued and better positioned for a changing market environment,” he continued.

“It’s also important to remember, given the size of the US economy, even “small” US-focused companies are large by international standards,” he said. This is important at a time when investors are rediscovering risk, as liquidity tightens due to rising interest rates, triggering a range of stresses. 

“With market valuations ranging up to $20 billion, however, US small and mid-caps are a well-traded and liquid asset class full of opportunities,” Kaynor said.

Register for FamilyWealthReport today

Gain access to regular and exclusive research on the global wealth management sector along with the opportunity to attend industry events such as exclusive invites to Breakfast Briefings and Summits in the major wealth management centres and industry leading awards programmes