With megacaps dominating during the rally, Julian Howard argues that overlooked US mid-cap stocks now offer compelling fundamentals, including valuations and the sector make-up amid a booming US economy. Technology still has its place, but investors could benefit from a broader US equity mix.
05 August 2024
1960s pop music trailblazers The Beatles were famously dominated by the Lennon-McCartney songwriting partnership, and of course the accolades were richly deserved. But the quieter writing partner was of course George Harrison, whose contribution may have been less high profile but still yielded legendary work including Here Comes the Sun and While My Guitar Gently Weeps. In a similar vein, US stocks have been dominated of late by the megacaps and in particular technology stocks including the so-called “Magnificent Seven”, to the seeming exclusion of everything else. The case for US megacaps remains strong, and right now rests on the persuasive idea of supplying a societal technology revolution driven by Artificial Intelligence (AI). This secular case is not about to go away anytime soon and readers looking for an excuse to dump all their US large cap holdings to take immediate profits will find no encouragement here. Instead, there is a case for an accommodation that can tap into the potential broadening of equity market leadership. Just as with The Beatles and other great bands, markets are not always about one or two high-profile driving forces, and there is often space for other areas to thrive simultaneously. Enter then US mid-cap stocks.
The valuation case for mid-caps
For convenience, the S&P 400 Index provides a reasonable proxy for this part of the equity market, with the average constituent having a market cap of USD 5.8 billion1 compared with USD 71.8 billion1 for the S&P 500 and USD 2.9 billion1 for the Russell 2000 small cap index, according to S&P and FTSE Russell respectively. The names in the mid-cap segment may not be as familiar as Microsoft or Coca-Cola but are still solid, recognisable businesses such as Alcoa, Under Armour and Mattel. While dedicated stockpickers will see opportunities within this (only very) slightly less liquid and well-known part of the US equity landscape, the US mid-cap arena is, in our view, most appealing at the aggregate level for a number of reasons. Firstly, the S&P 400 offers better value than the S&P 500, trading at 18.0x forward price/earnings2 as at 24th July when compared with the S&P 500, which is trading at 23.0x1. The S&P 400 is therefore trading at a discount of nearly 23%3 versus US large caps, with the average discount since 1995 in fact being no discount at all, but a very small premium. While there is no law of investments that says that today’s discount must one day close - Europe’s versus the US never seems to - it does mean that mid-caps have theoretically more potential to perform well than large caps from here, should the right catalysts present themselves. For some, an even more convincing way to look at mid-caps is through the prism of their relative yields. The S&P 400 enjoys an effective forward earnings yield of 5.6%4 as of 24th July, compared with the S&P 500’s 4.3%, which itself is barely more than the 4.2% yield1 offered by the 10-year US Treasury note, an instrument widely regarded as guaranteed, with virtually no risk of the US Treasury defaulting on its obligations.
Sector diversification matters when the chips are down
Looking at the underlying sector mix, US mid-caps also appear more evenly balanced than the S&P 500. Broad technology stocks make up fully a third of the S&P 500, but just 12%1 in the S&P 400. There is of course much to admire about technology companies and their long-term ability to monetise innovation, but investors looking to diversify their US equity exposure slightly in favour of today’s thriving US real economy may appreciate US mid-caps’ higher allocations to more domestically focused sectors, such as consumer discretionary and industrials as well as real estate.
Discounted diversification - US mid-caps trading significantly cheaper than large caps:
From 31 Jan 1995 to 24 Jul 2024
Past performance is not an indicator of future performance and current or future trends.
Source: Bloomberg
Source: Bloomberg
What could shine the performance spotlight on mid-caps?
With the underlying case laid out, what then would the catalysts be for strong relative US mid-cap equity performance from here? Their exposure to domestically orientated stocks points to US economic growth being an important driver for their earnings. And the good news is that the US economy has been booming of late, driven by government programmes such as the CHIPS & Science Act and the Inflation Reduction Act, as well as consumer spending driven in part by pandemic stimulus cheques. The US presidential election is unlikely to see this largesse reversed, with neither party focusing on reining in the (admittedly sizeable at -5.6%1) US budget deficit. As such, tax cuts under a second Trump term or further stimulus initiatives under a potential Harris administration should support continued consumer confidence and therefore economic growth, albeit not quite at the pace seen this year. The Bloomberg survey of economists highlights America’s still-favourable growth pathway, with a consensus growth rate for the US of 2.3% for 2024, 1.8% for 2025 and 2.0%*1 in 2026. Compare this with say the eurozone, with its respective 0.7%, 1.4% and 1.3%*1 growth rate forecasts.
* - These economic growth forecasts are predictions and that there is no guarantee that future growth will occur at these rates.
Mid-caps should see outsized benefits from rate cuts
Then there is arguably the potential start of a US monetary policy easing cycle to look forward to. With inflation now down to 3.0%, the case for the Federal Reserve cutting rates from the current 5.25%1 upper bound will become harder to resist. This is not least because keeping rates where they are as inflation cools automatically raises real rates and acts as an ever-harder brake on the economy. If and when interest rates do come down, US mid-cap stocks should disproportionately benefit given that they are more closely connected to the US real economy and consumer than the S&P 500, per the sector point above. They could also enjoy outperformance as rates come down since the relative advantage of the megacaps’ huge cash piles (a cool USD 108 billion in the case of Google parent Alphabet5) will become less important. Finally, and without detracting from the long-term case for megacaps, some profit-taking in the large tech firms could also see money looking for a fresh ‘story’ to buy into. The choppier performance of both the Nasdaq and the S&P 500 Index since mid-June suggests some investors may be re-assessing their broader US allocations, with mid-caps one of the potential beneficiaries.
The right sensitivity, right now – US mid-cap earnings’ are closely linked with US economic growth:
From 31 Mar 1996 to 31 Mar 2024
Past performance is not an indicator of future performance and current or future trends.
Source: Bloomberg
EPS = Earnings per Share
Source: Bloomberg
EPS = Earnings per Share
The era of large cap dominance of US - and indeed global - equities may or may not end in 2024 but the case for other sectors of the markets to thrive independently is becoming more convincing. US mid-caps offer compelling valuations and a well-diversified, economically correlated sector mix as a solid starting point. Combine with today’s circumstances of a strong US economy, the (eventual) prospect of lower rates and some signs of measured profit-taking in this year’s US equity winners and the rationale for a broader US equity allocation that includes US mid-caps - even if only via a simple index exposure - becomes more appealing. In groups of all kinds, to achieve great things every member has to pull their weight and play their part in the performance. George Harrison might have been overshadowed by the bigger personalities of Lennon and McCartney but The Beatles would have been much the poorer without him.
1 Source: Bloomberg
2Also known as forward P/E, this reflects and average of index constituents’ share prices dividend by consensus forecast of their future earnings. This is a predication and there is no guarantee than the forecasts will be realised.
318x relative to 23x, suggesting (but not guaranteeing) that mid-caps could by 23% cheaper than large caps, should these forecasts turn out to be accurate.
4This represents a comparison of consensus forecasts related to yields, typically from dividend payouts, by companies in future, relative to their share prices. These forecasts are predictions, are not guaranteed and may not turn out to be accurate.
5As at 31 March 2024, cash, cash equivalents and marketable securities, such as short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. https://abc.xyz/2024-q1-earnings-call/
2Also known as forward P/E, this reflects and average of index constituents’ share prices dividend by consensus forecast of their future earnings. This is a predication and there is no guarantee than the forecasts will be realised.
318x relative to 23x, suggesting (but not guaranteeing) that mid-caps could by 23% cheaper than large caps, should these forecasts turn out to be accurate.
4This represents a comparison of consensus forecasts related to yields, typically from dividend payouts, by companies in future, relative to their share prices. These forecasts are predictions, are not guaranteed and may not turn out to be accurate.
5As at 31 March 2024, cash, cash equivalents and marketable securities, such as short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. https://abc.xyz/2024-q1-earnings-call/
Important disclosures and information
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information contained herein. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Investors could lose some or all of their investments.
The S&P 500 Index is a stock index tracking 500 of the largest, publicly traded companies in the US. The S&P 400 Index, also known as the S&P MidCap 400 Index, is a stock market index that measures the performance of 400 mid-sized publicly traded companies in the US. The Russell 2000 Index is a small-cap index that makes up the smallest 2,000 stocks in the Russell Index in the US.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in indices which do not reflect the deduction of the investment manager’s fees or other trading expenses. Such indices are provided for illustrative purposes only. Indices are unmanaged and do not incur management fees, transaction costs or other expenses associated with an investment strategy. Therefore, comparisons to indices have limitations. There can be no assurance that a portfolio will match or outperform any particular index or benchmark.
This article contains forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.
This disclosure shall in no way constitute a waiver or limitation of any rights a person may have under such laws and/or regulations.
In the United Kingdom, this material has been issued and approved by GAM London Ltd, 8 Finsbury Circus, London EC2M 7GB, authorised and regulated by the Financial Conduct Authority.
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information contained herein. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Investors could lose some or all of their investments.
The S&P 500 Index is a stock index tracking 500 of the largest, publicly traded companies in the US. The S&P 400 Index, also known as the S&P MidCap 400 Index, is a stock market index that measures the performance of 400 mid-sized publicly traded companies in the US. The Russell 2000 Index is a small-cap index that makes up the smallest 2,000 stocks in the Russell Index in the US.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in indices which do not reflect the deduction of the investment manager’s fees or other trading expenses. Such indices are provided for illustrative purposes only. Indices are unmanaged and do not incur management fees, transaction costs or other expenses associated with an investment strategy. Therefore, comparisons to indices have limitations. There can be no assurance that a portfolio will match or outperform any particular index or benchmark.
This article contains forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.
This disclosure shall in no way constitute a waiver or limitation of any rights a person may have under such laws and/or regulations.
In the United Kingdom, this material has been issued and approved by GAM London Ltd, 8 Finsbury Circus, London EC2M 7GB, authorised and regulated by the Financial Conduct Authority.