Are overlooked small- and mid-cap stocks about to surge?

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). 

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 high².

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.

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 EBITDA to servicing debt, more than 3x 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.

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%–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. team can advise how SMID-cap stocks might fit into your equity portfolio and support your family’s long-term financial goals.

¹“The largest mega-cap stocks include Nvidia, Microsoft, Apple, Amazon, Meta, Alphabet, Tesla. Past performance is no guarantee of future results. It is not possible to invest directly in an index. Source: Bloomberg Finance LP. Data as of May 31, 2024. 

²“U.S. Small/Mid-Cap Strategy: The U.S. SMID Outlook—2024,” J.P. Morgan Global Market Strategy, January 2024. 

³“J.P. Morgan Private Bank Mid-Year Outlook: A strong economy in a fragile world,” June 2024.