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Are Small-caps and Mid-caps Bargains?

Many investors and traders have avoided small-cap and mid-cap stocks over the past year as money shifted into the relative safety of the bigger and more liquid large-cap stocks. It is understandable during periods of market uncertainties investors tend to favor the larger and more stable companies.

As prices plateaued in the lesser-known companies, the larger-cap counterparts went on a sharp acceleration to new record highs led by the mega-cap technology stocks. It is not that the small/mid-caps have done poorly over the exceptionally long term (i.e., decades) the problem is that in the recent bull rally smaller and lesser-known companies have trailed the bigger ones by such large margins that there is a visible gap between the two assets. It makes many investors question where the discrepancy in performance is permanent.

The Russell 2000 Index is a popular benchmark index for the small-cap market, and the Russell 1000 is a benchmark index for the large-cap market. Russell 1000 has outperformed Russell 2000 by an annual average of 4-percentage points over the past 5-years and by 2.5 points over the past 10-years. Historically, the divergences are noticeable because the small-caps tend to firmly outperform the large caps since small-caps must generate higher returns to attract investors for taking higher risks. Except that this has not been the case.

What are the reasons for the small and mid-caps underperformances? Is this an aberration or permanent? Will the longer-term trend of small-caps outperformance against large caps revert by to its mean?

Some blame the proliferation of index-based passive funds (i.e., S&P 500 Index funds) and ETFs (i.e., SPY) as one of the driving forces behind the recent large-cap outperformance cycle.

Another popular explanation is the wide use of technology favors larger caps over small to mid-caps. Technology tends to help large global companies gain a competitive edge over the smaller domestic-focused companies. (i.e., better productivity, more efficient supply chains, broader and deeper distribution, better marketing, etc.).

The historically low global interest rate environment also allows larger multi-national companies to excel as they can easily tap into cheap money resulting in higher future growth rates versus smaller companies.

Investors are social creatures that engage in herding. Herding occurs when investors follow the crowd instead of their analysis. Instead of independently seeking out information on its own merits, people often use the actions of the masses as a guide to consensus market behavior. Is this another reason investors favor large caps?

Are small-caps and mid-caps now bargains and value plays? Is it now time for longer-term investors to revisit the out-of-favor and under-owned small-to-mid-caps?

Source: Courtesy of Federal Reserve Bank of St. Louis and

Source: Courtesy of Federal Reserve Bank of St. Louis and

Source: Courtesy of

Source: Courtesy of

Source: Courtesy of

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