The case for small and mid caps

Segmenting the market

The market value of companies listed on stock exchanges around the world varies enormously. Apple became the first firm ever to reach a valuation of US$3 trillion, in early 2022.¹ The smallest firms, on the other hand, are typically worth in the millions of dollars.

A useful way to begin this discussion is to segment companies in terms of their market capitalization, or “market cap.” In this way, each listed company can be broadly categorized as large cap, mid cap or small cap, depending on its market value. It is the large cap stocks that investors are usually most familiar with, and which dominate well-known market indexes.

Looking beyond the large caps

Although it is true that large caps frequently make the news, investors might not want to overlook the wide range of mid caps and small caps available, as they may offer a higher growth and return potential.

These companies may, after all, be headed toward becoming large cap companies. The likes of Apple, Microsoft and Amazon began life as small caps or mid caps. As they grew to become superstars, their valuations multiplied several-fold, and those who invested early reaped the rewards of holding these so-called “multi-baggers” – that is, companies whose valuations increase by many multiples.

The difficulty, of course, lies in identifying future industry leaders at their early stages of growth: keep in mind that for every Apple that makes it, countless others don’t. This is made more challenging by the fact that investment analysts focus most of their research efforts on large caps, which make up the bulk of major indexes and investment portfolios.

Yet therein lies the opportunity, since the relative lack of research on mid caps and small caps increases the likelihood that high-quality businesses with tremendous growth potential are flying under the radar – and trading at attractive valuations.

Characteristics of the small, mid and large cap segments

What’s also important for investors to understand is that the small and mid cap segments of the market may have differing characteristics compared with the large cap segment, as the table below illustrates.

Table 1. Typical characteristics of the large cap, mid cap and small cap segments

Over the past 25 years or so, taken as a market segment, global small caps have generated higher returns than large caps (see Figure 1). Looking ahead, new leaders will continue to emerge from the small and mid cap segments, in part due to the difficulties incumbents face in staying ahead of the curve. After all, large established firms may not have the appetite to develop new, disruptive technologies or ways of operating.

Figure 1. Long-term total returns profile comparison (US$)

There is no shortage of examples of this in action. Take electric vehicles: while it may be more challenging for the world’s most established car manufacturers to make a hard pivot to focus on electric engines, Tesla has had no such concerns.

Successful small and mid cap companies may also make inroads into markets held by incumbents much faster than expected. Twenty years ago, few would have imagined the force Amazon has become in retail. Amazon founder Jeff Bezos famously predicted his company would eventually fail, and that lifespans of large companies “tend to be 30-plus years, not a hundred-plus years.”²

The reality is that just a handful of today’s small caps and mid caps will one day emerge as future leaders in their fields. Defining the ingredients of success is often difficult, as it requires understanding the competitive nature of the market, the competitors, the financial position of a company and the unique product or service that differentiates it.

Successful companies in the global mid cap universe are typically structural winners, technology disruptors, innovators, category killers or brand leaders. Some are unique niche operators or specialists that dominate their field. Others are part of a large global theme. Sectors such as technology, health care, globally focused consumer and industrials have more recently been home to such business models.

Table 2. Examples of small and mid cap themes

Many of these businesses are also founder-led. Where they are, their management teams tend to be innovative and agile, and their interests are generally strongly aligned with those of outside shareholders.

The benefits of active management

Recent market challenges have highlighted the importance of investing in high-quality names, characterized by sound balance sheet structures that enable companies to weather more challenging environments. Finding such companies takes work: it’s a research-intensive process. Investing in a fund that has this kind of active management brings additional advantages for investors, as investment teams can select opportunities from a much broader universe than those available in the benchmark index, as well as taking active positions across countries, sectors and companies.