Why it’s a ‘fantastic time’ to add small- and mid-caps

Large-company U.S. stocks have been beating up on the little guys of late.

The S&P 500, whose median company has a market capitalization (share price times shares outstanding) of more than $31 billion, has returned an annualized 13.6% over the past five years. That trounces the 9.7% return of the S&P Mid-Cap 400 (median market cap: $5.6 billion) and the 7.7% return in the S&P Small-Cap 600 (median market cap: $1.5 billion).

So-called large-caps have a lot going for them. These are the stocks that make up the most popular index funds and the household names on the lips of amateur traders and investment analysts alike.

It makes sense, then, that many investors have a huge chunk of their portfolio in large-caps. But it may make sense to branch out to smaller stocks, too, experts say.

That’s because small- and midsize-company stocks have two important factors working in their favor. For one, because investors have been so busy bidding up the price of the market’s biggest stocks, the smaller ones can currently be purchased at a relative bargain.

What’s more, over the course of market history, smaller names have tended to outperform larger stocks over long periods.

Add it all up, and “there’s no question it’s a fantastic time to be diversifying into small- and mid-caps right now,” says Greg Marcus, managing director at UBS Private Wealth Management.

When financial pros refer to investments being “cheap” or “bargain-priced,” they’re typically referring to valuation — what an asset is being traded for compared with its estimated worth.

One common valuation metric for stock is the price-to-earnings ratio, found by diving a company’s share price by its earnings per share. The higher the ratio, the more investors are paying for a smaller chunk of a company’s earnings. By comparing a stock’s P/E ratio with what it’s been historically, or the ratios of peer companies, analysts can determine whether a company looks over- or undervalued.

Stocks in S&P small- and mid-cap indexes both currently trade at about 14 times estimated earnings for 2024, compared with a ratio of about 20 for the S&P 500. That means small- and mid-caps trade at a roughly 30% discount to large-caps.

What’s more, small and medium stocks are looking cheap relative to their history. Midsize stocks are trading at a 14% discount relative to their average P/E dating back to 2005, according to data provided to CNBC Make It by CFRA chief investment strategist Sam Stovall. Small-company stocks are trading at a 19% discount to their historical average.

For smaller stocks, that spells “relative attractiveness” versus large-caps, says Stovall. “It either means that large-caps are grossly overbought or small-caps are grossly oversold, or a combination of the two. Mid-caps are not very far behind small-caps.”

In other words, either large-company stocks are currently overpriced, or smaller ones are underpriced. By buying now, you theoretically reap the rewards in your portfolio if and when valuations revert to their historical means.

Many financial planners recommend parking the bulk of your investments in a diversified, large-company U.S. stock mutual fund or exchange-traded fund. But if you’re hoping to participate in decades worth of stock-market gains, it may be worth investing in funds that own small- and mid-cap stocks, too.

“You want partake in the success of the U.S. economy,” says Jeremy Straub, founder and CEO of financial advisory Coastal Wealth. “That means businesses that are in the U.S. at all parts of that businesses lifecycle — when they’re starting out as a smaller size company, up to the big behemoths that we know as household names.”

Ideally, an investment in a smaller stock pays off when that firm grows first into a mid-size company and then into a market-leading multinational, its share price steadily climbing along the way.

Naturally, many small- and medium-size firms don’t make it all the way to the top. But small- and mid-cap stocks have rewarded investors seeking that kind of growth by beating the S&P 500 over long periods.

In an analysis of foreign and U.S. investments from December 1998 through June 2023, researchers at index provider MSCI found that small-cap stocks outperformed large firms over 15-year periods about 9 in 10 times. From November 1991 through September 2023, mid-caps outperformed both large- and small-caps, according to data from Invesco.

However, the latter analysis also noted that smaller-company stocks tend to come with more volatility, as they tend to be more sensitive to swings in the economy. That means it makes sense to keep most of your portfolio in larger stocks, which tend to offer more stability.

Still, you’d be wise to have some sort of mix, says Straub, which will come in handy when different types of companies go in and out of investors’ favor in the short term.

“The reason you buy large and small companies, is you don’t know which ones are going to perform when,” he says. “Sometimes one or the other will be over- or undervalued. Having investments in each gives you exposure when that asset does well, and you make money.”

If you’re curious about the effect adding smaller-company stocks may have on your investments, check with your financial advisor to see what might make sense for your portfolio.

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