Conventional wisdom has long held that investing in small-capitalization stocks has the potential to reward investors with excess returns relative to larger stocks. Generally speaking, the historical record supports this, as small caps have materially outperformed large caps over most extended market periods. However, structural changes have emerged in the small-cap universe that imply the returns of the past might not extend to the future unless investors alter investment approaches.
The small-cap universe has traditionally been fertile ground from which relatively young, promising companies can raise capital. The public markets typically have offered depth, liquidity and valuations at a considerable premium not easily found in the private market. These benefits have outweighed the demands placed on public companies: reporting requirements, quarterly scrutiny and often steady pressure from investors to meet growth and profitability targets.
Over the past decade, regulatory changes and a significant expansion of private equity funding has altered the cost/benefit profile of public equity. This has resulted in fewer small companies going public. As companies remain private longer, the small-cap universe suffers a decline in the replenishment cycle.
A new funding environment
Historically, a steady influx of new companies has been instrumental in keeping the small-cap universe invigorated with opportunities. However, the supply of new public companies has slowed markedly. From 1980 to 2000, the U.S. averaged 310 initial public offerings annually. Between 2001 and 2015, the average declined to 111 IPOs.
Further, the composition of the IPO market has changed post-2000. From 1980 to 2000, small firms represented 56% of all IPOs. From 2001 through 2015, only 35% of IPOs were small companies.
At the same time, the private market has stepped in to fill the funding requirements of small companies. The mechanism by which a growing number of small companies are funded has shifted from the public market to a new asset class — late-stage private equity.
Moreover, companies are now staying private for longer periods of time. In 2015, the median age of a venture-backed company going public is nine years, 50% longer than 2000 when the average was six years.
Implications for investors
With small-cap companies no longer as plentiful and late-stage equity sources stepping into the fray in lieu of the traditional IPO path to funding, investors seeking the absolute returns historically found in small-cap investing might wish to explore other avenues.
One natural place to turn is midcap stocks. Similar to small caps, midcaps present an opportunity to invest in a well-managed, thriving company that other investors may have yet to discover. While midcap firms can be well managed and healthy, they often lack the Wall Street coverage of their large-cap brethren. As a result, midcaps can offer an opportunity to be one of fewer investors in a company with “hidden” value.
Midcaps also benefit from their size relative to small caps. The midcap space has traditionally offered a more attractive risk/return profile than the small-cap universe due to superior quality companies (higher return on assets, better earnings growth). Over the past 10 years, midcaps have generated better returns (7.86%) than small caps (7.06%) and have taken on less risk (17.9% vs. 20.2%).
Further, allocating to midcap public equity provides the investor entry to these growing companies when they enter the public market as midcap companies, bypassing the small-cap public company stage altogether.
Late-stage private equity is another investment approach to the midcap space. Dedicating capital to late-stage private equity allows investors access to growing, valuable small companies that are seeking to delay access to the public markets until they grow larger. With more companies fitting into this definition now, there are ample opportunities to invest this way.
A barbell approach
In light of these developments, investors might find a barbell approach to midcap company investment particularly useful: In lieu of small-cap public equity, allocate to both late-stage private equity and to midcap public equity. With this approach, investors can truly get the “best of both worlds” by accessing successful companies before they reach maturity — whether through public investing or private funding.
As more alluring companies enter the public markets as midcaps, the midcap space will likely increase in quality relative to small caps and the return differential might widen further. Due to these dynamics, public market investors may expect midcaps to outperform small caps in the current environment.
For all of these reasons, we believe midcaps are the new small caps.
Mark Farrell is director of institutional marketing and private client services for Vaughan Nelson Investment Management, Houston. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.