The case for small and mid caps

0:05Pushkin. Some investment themes in life just come around over and over again. Time to buy UK, time to buy Europe, time to buy Japan. Sometimes it works, sometimes it doesn't. But another one to add to the list is time for small caps. And guess what? This one is doing the rounds again. Today on the show, we're asking, is this wishful thinking from the downtrodden, overlooked small cap nerds? Or are we finally on to something here? This is Unhedged, the markets and finance podcast from the Financial Times and Pushkin. I'm Katie Martin, a markets columnist here at the FT in London, and I'm five foot two inches tall, which makes me biased towards small caps.

0:52Now, listeners, I don't want to confuse you, but we have not one but two Americans on the show to discuss this today. If you do get confused, one of them sounds young and clever, and the other one is Rob Armstrong. Mr. Young and Clever... Couldn't resist. Mr. Young and Clever is Aidan Reiter, who did a stint in London before heading off to be Rob's underling on the Unhedged Newsletter a few months back. Aidan, are you missing London? The correct answer here is yes. Missing London immensely, but not necessarily missing the food. Okay, that's probably fair. Did you eat in the canteen? Is this the problem?

1:30Yes, it's all blaming on the canteen. Otherwise, a perfect metropolitan city. Look, the canteen's fine. It's pretty cheap. I like the canteen. Anyway, look, small caps, small caps. We keep getting false dawns on the old small caps. Aidan, give me a potted history because you guys have been writing about this on the Unheged newsletter recently, right? Yeah. So small caps for a long, long time had outperformed their larger counterparts, right? So just to be clear, we're talking about three indices. There's the S &P large cap. That's the S &P 500, which is kind of the make or break of the market.

2:03It's the standard what everybody looks at. There's the S &P mid cap, which is the S &P 400. So that's medium-sized companies. And then there's the S &P 600, which is the S &P small cap. So those are the smaller companies. We should note that people also look at the Russell 2000. But just for the sake of consistency, we looked at these three S &P indices. And for a really long time, those small caps were outperforming their bigger counterparts. And the thought was that once interest rates come down or came down, we would have this huge small cap resurgence this summer. And for a moment this summer, we saw it.

2:37They did really well a couple of weeks ago, but it's kind of been gone since then. Yeah, so there was a period back in the summer when there was like the biggest outperformance of small caps compared to the S &P 500 in like 40 years. Like these things really exploded. Well, there's a reason people kind of consistently root for small caps, which haven't done that great in the last 10 years or so, let's say, and really haven't done great since the pandemic. is that according to finance theory, which we all learned back at finance university, small caps are riskier than large caps. Small companies run into more trouble than big companies and that therefore you're supposed to get paid more for holding them over time.

3:22They're more volatile. So they should actually have higher returns over extended periods than big caps because you get paid more for holding a riskier asset. That's what the theory says. and the theory is not panned out, which means a lot of people who invest according to the theory have had a very frustrating couple of years. And so it's like, when is the thing that is supposed to happen going to happen? Yeah. When is the thing that we all heard about at Finance University actually going to happen? I mean, have they actually done flat out badly, or have they just done badly compared to those clever clogs in big tech?

3:58No, no. I mean, you've made money. So over the last five years, I'm looking at S &P Capital IQ before me on my computer. The S &P 500, the big daddy is up like 90 something percent. The mid caps are up 60 something percent and the S &P 600 is up 50 percent. So you're not exactly crying into your beer if you own small caps or mid caps. The issue is that your friend who just owned all the big companies is laughing at you while you drink your beer. And that is not fun. We can't have that. Yeah. No. It's worth noting, though, that small caps and mid caps are more economically sensitive. They are smaller companies that are more contingent, both not just on interest rates because of floating rate debt in theory, but also on whether consumers can come to the table, how the economy is doing vis-a-vis labor.

4:51So they're just sensitive overall. So especially in the past couple of years with COVID, with post-pandemic supply shocks, they have also just not fared better. But I think Rob would say the real picture here is that the large companies, the Magnificent Seven, have just done so, so well. Yeah. I do say that. Not only I would say that, I do. I say it now. I'm saying it. It's been crazy. Google, Apple, Microsoft, Meta, NVIDIA. I mean, they've had this astonishing run. They're almost a separate asset class. But I think even if you peeled those out of the S &P 500, the S &P 500, in fact, I know this, its performance has still been superior to the small caps, which is actually frustrating for another reason among people who made the mistake of going to finance university, which Which is that the small and mid caps are significantly cheaper on like a price to earnings or a price to book basis than the big companies.

5:44Yeah, it's about a third cheaper. Yeah. And actually, interestingly, the small caps and the mid caps, despite having very different profiles and different profitability, are about the same price. Right. So they're at a big discount. And, you know, as everybody likes to say, valuation is not a timing mechanism. Just because something's cheap doesn't mean it's going to return to fair value. But, you know, over the long run, that's what you hope to see is a mean reversion there. That hasn't happened. Extremely frustrating. So now we have to kind of confront the question. Is there something about the quality in the U.S.

6:17of these small and mid-cap indices that actually justifies? Is there something in the economic fundamentals that justifies their underperformance over time? Do you know the answer to that question? Aidan, do we know the answer to that question? We have some theories. So if you look at the margins in the S &P 400, and keep in mind that the S &P indexes of these mid-caps and the small caps, for the mid-caps and small caps, is the best of the best of small caps and mid-caps, right? So this is not the perfect sample. But even looking at that better than average sample, those companies have not been that profitable in the past couple of years, partially because the interest rate elements we discussed before, a lot of it because of the economic sensitivities they've had since COVID.

6:58But if you look at it, it's about 77 % of the companies and the S &P 400 are profitable. That is not a very good or high number. Yeah. Whereas 91 % of the bid caps are profitable and almost all the large caps are profitable. So there's actually a lot of loss leaders among the small caps. Yeah. Then if you look at their margins, it's not just that the margins of small caps and the bid caps have not done well vis-a-vis profits and earnings. It's that the large caps have done so incredibly well. Part of that is the types of companies that are in the large cap indices, right? You have software companies that just have amazing margins for relatively cheap products versus small companies making much more labor-intensive, cost-intensive goods that they then have to sell using large sales forces that cost a lot of money.

7:45But the point is, if you look over time, the large companies had been outperforming the mid-caps and the small caps on margins for a long time. But that difference has accelerated in the past couple of years. The gap is getting wider. Yeah. So the large companies are getting better, mostly driven by the super high earners like tech companies. And the small caps and mid caps just can't keep up. There's also the question of debt. Yeah. Well, this is a kind of interesting point. One of the favorite just so stories of Wall Street, when the nice man with the slick suit and the good hair comes to sell you the stocks, he says, well, small companies have more debt and they have more floating rate debt than big companies.

8:27And therefore, you should buy the small companies that I'm selling here because they will do better than the big companies when rates come down. And that's at least the market narrative that seemed to be at play a couple of weeks ago when we had this big small cap revolution. But it turns out there's a little problem with this theory, which is that it doesn't appear to be true. No, that is a problem. Is that because, you know, yes, you know, interest rates are falling. The Fed obviously cut rates by half a percentage point just a few days ago. But it's done that because the economy is slowing down a little bit.

9:04Right. So do those two forces kind of play off against each other? You know, so like Aidan was saying, they are economically sensitive. Maybe that just outweighs the rates thing. I think that's a good theory. But if you actually look at the amount of debt, like Aidan and I actually, looked at all the companies that are in the small and mid-cap indices we were studying, and we looked at their debt levels and at how much interest expense has been and how that's changed as rates gone up. And it looks to us like this idea that is so popular on Wall Street that they have higher debt burdens, more floating rate debt, and therefore, as rates go down, they will prosper mightily, this turns out not to be based very strongly, in fact.

9:56And it's just, yeah, economic sensitivity might occlude the picture a little bit. But the basic fact is, debt has not been that big a factor in the underperformance of the small and mid-cap indices. That's interesting. Yeah. One thing I wonder is, is it possible to blame all of this on private equity? Because, you know, another one of the theories that kicks around is that, you know, in terms of why these companies underperform, these smaller companies underperform, is that if you are a decent smaller company, you've been bought by private equity already and you're not in the big indices and you're not on public stock markets.

10:33So have those scoundrels from private equity kind of ruined the game for everybody else. It's very hard to track this data because the information about what was in small and mid cap indices in the past and information about who bought which company and whether the buyer was sponsored by private equity or not, all that data exists, but is scattered around a million different places. So I actually, while that theory that you just articulated is incredibly popular on Wall Street, and you hear it all the time from investors and analysts and so forth. It's very hard to draw that picture with accuracy.

11:17But I find it an extremely tempting theory. We know for a fact, A, that private equity loves to buy small American companies and take them private. We know for a fact, B, that the companies they most like to buy are the ones that we might call high quality, good, steady, repeating cash flows, et cetera, et cetera, maybe without much leverage so that they can then put tons of their own leverage on top of them. So I am always happy to point the finger at the wicked and iniquitous private equity gazillionaires, but I can't quote chapter and verse in terms of the stats on this. We should note that there might be a bit of a double-edged sword here, right?

12:00So right now we have rates are loosening up. M &A might kick off. These private equity firms might get a little more active in their buying. While that affects, if they're, say, they're buying the best companies in the small caps or mid-cap indices, that affects the profitability. You could say that there's also a valuation premium that it gets in this time. That will appear. Yeah, it'll appear. So people are like, oh, private equity is about to buy all these companies. Let me buy some stocks right now and get some payout. So it's a bit of a double-edged sword. They could be wrecking the index, but they also might be boosting valuations when the economy is good.

12:32Stop being nice about private equity. They love it when you're mean about them and they never email you to complain. We might not have the stats to ham, but certainly one thing anecdotally that people say to me is that there's lots of bargains to be found in small cap Japan, for example, precisely because there isn't as big of a private equity industry. And so there's loads of cheap little companies like kicking around in the bottom end of Japanese indices that are actually a really, you know, good bet if you know what you're doing and you're prepared to put the work in. You find the right fund manager who's really tuned in.

13:05Let me turn that kind of point around on you, Katie. A lot of the things we've said so far on this podcast could be applied to UK stocks. Does all of this just...

13:22Does this all... I mean, the same point applies. There's tons of people out there saying UK stocks are a screaming bargain. They've been neglected. They're in sectors that aren't necessarily fashionable, but they're at all at 11 times earnings or whatever the thing is, and we should all buy them. so is it all the same argument as you could make about uk stocks and is it true or false of uk stocks it is all the same in the sense that i mean again like we were saying right at the top of this podcast you know that buy uk is one of these kind of perennial big ideas that never goes away and almost never works very well but the additional kind of ingredient that you have for the uk in addition to the fact that it's cheap yes cheap things can get cheaper yes some things are cheap for a reason.

14:07But there really is a big effort underway in the UK now to revitalise public and private markets. There's a consultation underway to see how and whether it might be worth reforming bits of the pensions industry and pushing more money from pensions into equities rather than boring old bonds where lots of them have almost all of their resources. So there is possibly a kind of structural support to UK stocks that wasn't there previously, or at least there might be soon. But yeah, it's definitely the same sort of argument. UK is an extremely boring market. It's full of stuff like banks and insurers and resources companies.

14:45And actually, when the going gets tough, that kind of extra shield of boringness comes in quite handy for UK stocks. And it should mean if the market really is going off the mega cap kind of AI hype thing, Maybe there is a little bit more support for rinky-dink markets like ours. So presumably you've already got all of your net worth in UK stocks already. It's true. That's a requirement. When you join the FT, you have to put all your liquid wealth in the FTSE 100 or whatever. Just to make sure our listeners know, this is a joke. That's wonderful. What form did I sign in London? Oh, my God. So I actually am a bit of a believer in the theories we are talking about here.

15:35I do believe that over time, the huge and growing gap in performance between the big and the medium and the small, the huge and growing gap between the U.S. and everything else, the huge and growing gap between growth and value. I'm sort of keeping the faith that there'll be some mean reversion and that will happen. And I think the trade for me is particularly appealing with the mid caps. I think they don't. I mean, Aiden was talking before about the weakness and profitability in the small cap indices. I think that's true. We've seen their margins diminish more. There's more unprofitable companies.

16:16But the mid caps look like they're in a bit of a sweet spot. As Aiden said, they have the same valuation as the small caps. but they're better companies and they're more profitable. And, you know, I look at a list of the companies in the mid-cap indices and there's some high quality companies in there, you know? And so I kind of buy it. Acknowledging, of course, that it's been painful to be contrarian on these points for a long time. Yeah. I think it's worth noting, though, as you said with the mid-caps, there's a lot of companies in the mid-caps that are going to benefit just by their very nature from lowering interest rates, right?

16:53regional banks, insurers, that will have a better go of it once these things come down. So again, mid caps might be poised to benefit more from rates coming down than small caps, you know. If the economy responds to the rate cuts as expected, meaning activity starts to slowly pick up. U.S. activity has been, the U.S. economy has been kind of gently, gently cooling. And if we turn a bit of a corner there and we get a little warmer, I think Aiden's right. I mean, it's a tempting, it's definitely a tempting trade. But just to throw a little bit of doubt on this whole thing, one of the theories we heard a lot of asset managers and a lot of assets - I had everybody feeling good there for a second, Aiden, and you have to come in and ruin all the fun.

17:32Well, I have to ruin my fun with my big anti-large company tirade, which is maybe one of the reasons we've seen small caps and mid caps underperform in that margin of profitability widen over the past couple of years, is that a lot of small caps and mid caps are business-facing, right? Their business services, their banks that are working with the large caps. Now, the large caps have so much market share and have such strong positions post-pandemic. They've been able to squeeze their providers, which are the small caps and the mid caps. And if that continues, then will we ever really see small caps and mid caps stage a true comeback?

18:06Yeah. This is a version of the argument that the U.S. economy is increasingly oligopolistic. I always find that word very hard to say. There's so many syllables there. but uh that we have an increasingly oligopolistic economy where a few companies with immense market power everybody from walmart to apple put the squeeze on everybody oligopolistic is a really big word to be throwing into the pod i know it's early in the morning for that yeah listeners if you know any really really long words and you have strong opinions about small caps then uh go right ahead and email robert.armstrong at ft.com.

18:45Rob, I get quite a lot of emails to the both of us where people just put in rob.armstrong at ft.com. And so I get shouty emails. People are shouting at you, but I'm the only recipient. It's a nice system, actually. Okay. Yeah. But really quickly, Aiden, small and mid-caps, the big trade for Q4, yes or no? I think mid-caps look better, but I'm going to say no. You need to give me more time is my answer to that. I think over the longer run, mid-caps especially are very appealing. But for the next quarter, we're still in big company world. But, you know, you can't wait. They don't ring a bell when it's the exact right time to buy these things.

19:28So, you know, if you're asking me in my own portfolio, am I thinking about seriously about switching some of my exposure from big to medium? The answer is yes. hmm good stuff stay tuned because we'll be back in a sec with long short

19:55all righty now it's time for long short that part of the show where we go long a thing we love short a thing we hate i'm just going to find out what you guys have got going on. Aidan, are you long or short? I am long knitwear. It's starting to get a little bit of crisp in the air in New York. And I am personally very excited to put on sweaters. I have what some might call the Ashkenazi Jewish disease of always wanting to put on a knit sweater and then getting immediately sweaty when I put it on. But it's the thing that gives me a lot of joy sartorially in the winter. Yes. Don't you like it, Katie, that he used knitwear, which is neutral between your weird word jumper and our correct word sweater.

20:38So I think - London really influenced me. I'm going to take the exact opposite side of Aiden's trade. I am anti-sweater slash jumper. I think they get dirty too easily. They get holes and they cost too much money. I'm a jacket man. So I am short jumpers and long jackets. Kind of woolen jackets? Is that the deal? No, not woolen. I don't know, corduroy? Okay, well, you know, fashion wars over in the New York Bureau. I'm going to stay well out of it. Listeners, listen up again on Thursday, because we'll be back in your feed then.

21:19Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forges. Cheryl Brumley is the FT's Global Head of Audio. Special thanks to Laura Clark, Alistair Mackey, Greta Cohn and Natalie Sadler. FT Premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Katie Martin. Thanks for listening.

22:02We'll be right back.