Small to mid-cap equities in focus amid concentration risks

Small-to-mid cap fund managers predict opportunities for investors to reduce their concentration and valuation risk while maintaining strong growth potential.

Bell Asset Management investment officer and portfolio manager Ned Bell. Picture: Hollie Adams

As a handful of mega-cap tech stocks increasingly dominate the global sharemarket, small to mid-cap fund managers see an opportunity for investors to reduce their concentration and valuation risk while maintaining strong growth potential via SMID-cap equities.

Bond yields soared as US inflation data this week exceeded estimates for a third consecutive month.

The US 10-year bond yield hit a five-month high of 4.59 per cent versus 3.8 per cent at the start of the year, challenging valuations in developed stock markets, after record highs.

After rising 25 per cent since October, the S&P 500’s price-to-earnings ratio was almost 21 times.

Its earnings yield of 4.76 per cent offered the narrowest yield advantage over “risk-free” US Treasury bonds in two decades. But Amazon, Alphabet, Apple and Tesla buoyed the “Magnificent Seven”.

Alphabet and Amazon hit record highs on expectations of strong earnings growth from the AI boom.

While not denying the earnings potential of Magnificent Seven, global SMID-cap fund managers said the concentration of value of the biggest companies in global benchmarks exceeded that seen during the peak of the so-called dotcom boom in 2000.

“Concentration risk in the Mag 7 is obviously a huge issue,” said Bell Asset Management chief investment officer Ned Bell, who oversees a $2.5bn global SMID-cap fund.

“SMID-caps are the last Christmas presents under the tree because they haven’t had that rerating.”

The top-10 stocks in the MSCI All Country World Index account for almost 20 per cent of its value. The last time it got above 15 per cent was at the end of the last century.

The top-10 stocks in the Russell 1000 Growth Index account for about 55 per cent of its value versus 43 per cent at the peak of the dotcom bubble.

“The magnitude of concentration by name and by sector is massive,” Mr Bell said.

There are few cracks at this point. Apple and Tesla have been left behind this year but Nvidia has surged 83 per cent. But “Mag 7” earnings are expected to have risen 37 per cent in the year to March.

Ned Bell: “SMID-caps are the last Christmas presents under the tree.” Picture: Hollie Adams

Profits for the rest of the S&P 500 would fall 2 per cent, according to Bloomberg.

But Mag 7 profits growth is tipped to slow to 15 per cent this year versus 18 per cent for the rest of the S&P 500. Previously unloved groups are being upgraded as the US economy proves stronger than expected.

The flip side is that interest rate expectations are being revised up.

BofA was one of several US banks to revise up its interest rate forecasts after CPI data this week.

BofA US economist Michael Gapen increased his forecast of the so-called “terminal” or long-run Fed funds rate by 50 basis points to 3.5-3.75 per cent versus 2.6 per cent forecast by FOMC officials.

Higher interest rate assumptions should have more impact on expensive growth stocks as the earnings they are expected to generate in the future need to be discounted by the risk-free rate.

“The other elephant in the room is just the valuation,” Mr Bell said.

Mag 7 on average trades on a 12-month forward PE ratio of about 30 versus about 15 times for the average of global SMID-caps. Mag 7’s PE multiple has risen about 50 per cent since the end of 2022.

“We obviously had that huge growth meltdown in 2022 and since then we saw this massive PE rerating, on top of earnings upgrades,” Mr Bell said. “The PE rerating has been extreme.

“Mag 7 now trades at about a 62 per cent PE premium to the rest of the market.”

The growth meltdown in 2022 was caused by interest rate fears rather than any deterioration in the earnings outlook for Mag 7. After stronger than expected economic data and inflation data this year, the amount of rate cuts expected in 2024 has fallen to 43 basis points from 179 in December.

Mr Bell expects a “huge mismatch” between Mag 7 valuations and the rates outlook.

If the PE multiple of Mag 7 were to fall to 25 times, it would imply a 17 per cent fall in the index.

At the same time, a stronger than expected economic growth outlook could result in the PE multiple of global SMID-caps rerating from 15 to 20 times, implying a 33 per cent rise in the index.

“The global small and mid-cap asset class has strongly outperformed large-cap stocks over the long term,” said MFS Investment Management portfolio manager Nick Paul.

“While market leadership ebbs and flows over shorter periods of time, global SMID-caps appears well-positioned to potentially assume a leadership role in the next rotation.

“In our view, the opportunity set for small and mid-caps appears particularly attractive.”

Massachusetts-based MFS manages more than $615bn ($932bn) globally and it oversees about US$55bn in small and mid-cap equity strategies.

Mr Paul is co-portfolio manager of the firm’s international diversification strategy.

From the end of the dotcom boom to the start of the GFC, global small and mid-cap stocks significantly outperformed relative to their large-cap counterparts.

The MSCI ACWI SMID index returned 94 per cent versus just 21 per cent for the MSCI ACWI Large Cap Index.

Mr Paul sees a number of similarities with the current time. “Valuations potentially offer investors a buying opportunity not seen in decades,” he said.

The valuation of global SMID-caps relative to large caps is the lowest in decades, inflation and interest rates are similar to what they were in the run up to the GFC, and the concentration of value in large caps is above the peak of the dotcom bubble.

Paul said future spending trends might benefit a wider cohort of sectors and industries, and not just the mega-cap tech companies that garnered most of the spending in the past decade.

“Specific to small and mid-cap stocks, spending trends may be driven by a 70-year high in the average age of fixed assets as sales have benefited during past capex cycles,” he said.

A move to localisation, as governments and companies around the world onshore supply chains to improve their supply chain resilience, could also provide a tailwind to the SMID-caps asset class.

“We believe the local nature of small and mid-cap companies could work in their favour while large-cap company margins may come under pressure as benefits of globalisation subside as on-shoring gears up.”