Mega-cap tech stocks – the market’s darlings – continue to power forward. They have accounted for a staggering 60% of the S&P 500’s 40.5% return since the beginning of 2023.¹

Now, as earnings growth accelerates in a robust U.S. economy, the stock market rally is broadening beyond mega-cap tech. And it is shining a particular light on U.S. small- and mid- cap (SMID-cap) stocks. This market cohort offers the potential for long-term capital appreciation supported by durable profit growth. What’s more, given the concentrated market rally since the start of last year and renewed concerns around rates remaining higher for longer, these stocks now trade at a near-record valuation discount. 

But investors will need to be discerning. We prefer quality SMID-cap stocks that focus on profitability and growing competitive advantages. Some SMID-cap companies carry high levels of debt and a valuation discount for these stocks seems reasonable. However, today’s near-record discount in the highest-quality SMID-cap stocks does not. Indeed, high-quality smaller-cap stocks now trade at a near-record valuation discount versus their large-cap peers, despite having similar cash flows and profit margins. We believe that gap will narrow, creating a potential entry point. 

Source: Empirical Research Partners Analysis. Data as of April 30, 2024. *Note: Capitalization-weighted data, Small-capitalization Stocks (ex-Commodities & Biotech).

Durable earnings growth, strong long-term capital appreciation

U.S. SMID-cap stocks have generally underperformed U.S. large-cap stocks over the past 10 years. That dynamic partly reflects the dominance of mega-cap tech stocks. But here’s a fact that many investors miss: Over the past 10 years, SMID-cap companies have generally grown their earnings at a faster pace than their large-cap peers. Indeed, a vast majority of returns in SMID-cap stocks have been driven by earnings growth (versus multiple expansion). 

Source: JP Morgan Private Bank, FactSet. January 2024.

What explains that earnings growth differential? First, many SMID-cap companies are at the leading edge of innovation. That might involve developing breakthrough software or advances in industrial automation. Second, leading SMID-cap companies have streamlined business models with embedded competitive advantages in order to build – and sustain –leadership in fragmented markets. They’re the proverbial “big fish in a small pond.”

Not surprisingly, a combination of innovation and market dominance makes SMID-cap companies ideal targets for M&A activity. Over the past 30 years, 96% of public M&A targets in the United States have been SMID-cap firms. Last year, the average premium that large-cap companies paid to acquire SMID-cap companies reached 50%, a post–global financial crisis high.²

We believe SMID-cap companies will continue to deliver strong earnings growth. Our 2024 Long-Term Capital Market Assumptions estimate that U.S. SMID-cap equity returns will be robust over a 10-to-15-year investment horizon, even rivalling that of U.S. large caps (albeit with more risk). We believe building a portfolio of actively managed, attractively valued, high-quality SMID-cap companies can generate robust long-term returns while mitigating some of the risk.

Source: 2024 Long-Term Capital Market Assumptions (LTCMAs), expectations for risks and returns over a 10- to 15-year time frame. J.P. Morgan Asset Management’s LTCMAs are the product of a deep, proprietary research process that pools the quantitative and qualitative insights of more than 60 investment professionals.

An inefficient market ripe for stock picking

While we believe in the structural case for investing in SMID-cap stocks, selectivity is key. We note a wide dispersion in the quality of the underlying companies in the SMID-cap universe, which partly reflects the state of disruption in their businesses. Some companies either carry high levels of debt or do not generate earnings (U.S. small-cap companies dedicate over 30% of their Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) to servicing debt, more than three times their large-cap peers).³ Given investor concerns about rates staying higher for longer, the level and durability of earnings will become increasingly important.

Limited analyst coverage of SMID-cap stocks provides ample opportunity for active stock picking. Over 90% of SMID-cap stocks have minimal analyst coverage versus around 25% for large caps.

Source: "The US SMid Outlook - 2024", JP Morgan Global Market Strategy. January 2024.

Over the long run, investing in high-quality SMID-cap stocks—those with strong balance sheets, exceptional returns on equity, and durable and growing competitive advantages – has historically generated better long-term performance with less volatility than investing in the broad market alone. We believe that trend will persist, making it imperative to identify true high-quality companies. By definition, an index fund may not be able to make those distinctions. In the SMID-cap space, we believe, active management is critical. 

What this means for your portfolio

Especially after the past several years of mega-cap stock gains, you may have a greater percentage of your equity portfolio invested in large-cap stocks. Quality SMID-cap stocks offer not only the prospect for long-term growth, but also the potential portfolio diversification benefits from investing across the market-cap spectrum. And as we’ve noted, discounted valuations make for a potential entry point. 

How much might you consider allocating to SMID-cap stocks? We believe that allocating around 5% to 10% of an overall equity portfolio to SMID-cap stocks, assuming an appropriate time horizon and risk tolerance, can be additive to risk-adjusted returns. In other words, a small shift can make a meaningful difference.

We can help

Your J.P. Morgan advisor can advise how SMID-cap stocks might fit into your equity portfolio and support your family’s long-term financial goals.

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All companies referenced are shown for illustrative purposes only, and are not intended as a recommendation or endorsement by J.P. Morgan in this context.

JPMAM Long-Term Capital Market Assumptions

Given the complex risk-reward trade-offs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations. Please note that all information shown is based on qualitative analysis. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. Note that these asset class and strategy assumptions are passive only – they do not consider the impact of active management. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell securities. Forecasts of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. The outputs of the assumptions are provided for illustration/discussion purposes only and are subject to significant limitations.

“Expected” or “alpha” return estimates are subject to uncertainty and error. For example, changes in the historical data from which it is estimated will result in different implications for asset class returns. Expected returns for each asset class are conditional on an economic scenario; actual returns in the event the scenario comes to pass could be higher or lower, as they have been in the past, so an investor should not expect to achieve returns similar to the outputs shown herein. References to future returns for either asset allocation strategies or asset classes are not promises of actual returns a client portfolio may achieve. Because of the inherent limitations of all models, potential investors should not rely exclusively on the model when making a decision. The model cannot account for the impact that economic, market, and other factors may have on the implementation and ongoing management of an actual investment portfolio. Unlike actual portfolio outcomes, the model outcomes do not reflect actual trading, liquidity constraints, fees, expenses, taxes and other factors that could impact the future returns. The model assumptions are passive only – they do not consider the impact of active management. A manager’s ability to achieve similar outcomes is subject to risk factors over which the manager may have no or limited control.

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