A window of opportunity for outperformance has opened up for smid caps
The sharp underperformance of small and mid-sized stocks since the middle of 2018 has become excessive.
At least three catalysts should allow this universe to deliver better returns in the coming quarters.
SMID cap stocks: outperformers over the long term
Over the long term, small and mid-capitalisation stocks outperform their larger sized counterparts. This is due to their structurally higher earnings growth potential. Only when growth fears accumulate or recession takes over do they underperform. This is the case since June 2018, because leading indicators keep deteriorating and earnings forecasts continuously are revised down. Another reason for underperformance when the macro background becomes less supportive is the higher proportion of debt in their balance sheets. Clearly, the higher share of cyclical sectors is another headwind in such circumstances.
Exaggerated macro fears
The economic news flow has been deteriorating since the start of 2018. The geopolitical environment has become more difficult and added to uncertainties, particularly hurting corporate appetite to invest. A certain number of leading indicators points to stabilisation of the negative momentum and some improvement for coming quarters. Recession fears are premature in our opinion and therefore a window of opportunity for outperformance has opened up. This is the first reason to upgrade our stance on SMId caps.
Higher exposure to cyclicals becomes a positive feature
A second reason for turning more positive on SMID caps is the higher presence of cyclicals among them than among large caps. Even though we expect global growth to remain below potential, very subdued, an improvement in sentiment concerning the economic cycle should help SMID caps to deliver relative better returns.
Valuations have become more attractive
A third catalyst for better returns going forward is the improvement in relative valuations. Earnings forecast downgrades have gone a long way recently, particularly for SMID caps. From now on, with expectations having become more realistic, more confidence can be placed on valuations and their comparison with long-term averages. This analysis shows that valuations have become more attractive and supports a more favourable outlook.
A brightening technical configuration
The technical picture has improved. Over the last few months, the steepness of the relative downtrend has given way to stabilisation of the relative performance, a prerequisite for an outperformance phase.
Overall, the environment is less dire than generally feared. This creates an opportunity for fund inflows into equity markets, among others towards SMID caps, which have suffered significantly since the middle of 2018.