Financial Professionals

July 9th, 2024

Mega-Caps Get The Headlines, But Investors Can Benefit From Thinking Small 

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While Mega-Cap Stocks Shine, Investors Should Think Small

Readers have likely seen the statistics and financial media headlines. Mega-cap stocks—namely major technology companies—have been driving a disproportionate share of total U.S. stock market returns. From the beginning of 2023 to the end of May 2024, a small handful of the biggest technology companies have driven approximately 60% of the S&P 500’s 40+% gain.1

This week’s column is not a declaration that this outperformance is over. In fact, earnings suggest the opposite. The largest tech players have been growing earnings at a staggering clip, and strong positive equity returns have accompanied and often led this growth. The outlook for Q2 and beyond looks like more strength.

Total earnings for the Technology sector are expected to be up +15.5% on +9.5% higher revenues for the second quarter, with a 119-basis point expansion in net margins (see chart below). These are very strong numbers.

Source: Zacks Investment Research2

While price appreciation for mega-cap tech stocks has a fundamental driver in earnings growth, it has also resulted in significant multiple expansion for the sector. For some investors, this strong performance could mean your portfolio has greater exposure to large-cap stocks than it did a year ago (assuming you have not rebalanced).

And that’s where “thinking small” comes in.

From a pure valuation standpoint, high-quality small-cap stocks trade at a historically large discount to their large-cap peers, even though many of them have similar profit margins and free cash flows. Indeed, over the past decade, small- and mid-cap companies have grown earnings—on average—faster than their large-cap peers. For small caps, stock price appreciation over that time has lagged their large-cap peers, but has also been driven far more by earnings growth than multiple expansion. That’s important.

I want to be fair here, however. There are almost always a sizable number of small-cap companies with high growth rates, but also high debt levels and negative earnings. On average, small caps spend about a third of their EBITDA servicing debt, which is much higher than what large caps spend. And in a higher interest rate environment, elevated debt loads could raise the risk profile of this category of small and mid-caps.

But for the active investor with a focus on earnings growth, strong balance sheets and free cash flows, and balanced risk-adjusted performance and diversification, small- and mid-cap stocks could offer a unique opportunity in the current environment.

Bottom Line for Investors

With all the hoopla surrounding mega-cap tech stocks and enthusiasm about Artificial Intelligence, there’s been a narrative that technology stocks are the only sector where investors can generate returns. But history reminds us that high-quality small- and mid-cap stocks have delivered competitive returns to the broad stock market over long stretches of time, in many cases outperforming.

Disclosure

1 JP Morgan, June 25, 2024. https://www.jpmorgan.com/insights/investing/investment-trends/are-overlooked-small--and-mid-cap-stocks-about-to-surge

2 Zacks Investment Research, June 28, 2024. https://zacks.com/commentary/2295224/q2-earnings-growth-forecasted-to-hit-two-year-high


DISCLOSURE

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts as an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole.

Any projections, targets, or estimates in this report are forward looking statements and are based on the firm’s research, analysis, and assumptions. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are subject to change without notice. Clients should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed in this presentation.

Certain economic and market information contained herein has been obtained from published sources prepared by other parties. Zacks Investment Management does not assume any responsibility for the accuracy or completeness of such information. Further, no third party has assumed responsibility for independently verifying the information contained herein and accordingly no such persons make any representations with respect to the accuracy, completeness or reasonableness of the information provided herein. Unless otherwise indicated, market analysis and conclusions are based upon opinions or assumptions that Zacks Investment Management considers to be reasonable. Any investment inherently involves a high degree of risk, beyond any specific risks discussed herein.

The S&P 500 Index is a well-known, unmanaged index of the prices of 500 large-company common stocks, mainly blue-chip stocks, selected by Standard & Poor’s. The S&P 500 Index assumes reinvestment of dividends but does not reflect advisory fees. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor. An investor cannot invest directly in an index.

The Russell 1000 Growth Index is a well-known, unmanaged index of the prices of 1000 large-company growth common stocks selected by Russell. The Russell 1000 Growth Index assumes reinvestment of dividends but does not reflect advisory fees. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

Nasdaq Composite Index is the market capitalization-weighted index of over 3,300 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks, as well as limited partnership interests. The index includes all Nasdaq-listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debenture securities. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

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The Bloomberg Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index is a modified market capitalization weighted index composed of preferred stock and securities that are functionally equivalent to preferred stock including, but not limited to, depositary preferred securities, perpetual subordinated debt and certain securities issued by banks and other financial institutions that are eligible for capital treatment with respect to such instruments akin to that received for issuance of straight preferred stock. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The MSCI ACWI ex U.S. Index captures large and mid-cap representation across 22 of 23 Developed Markets (DM) countries (excluding the United States) and 24 Emerging Markets (EM) countries. The index covers approximately 85% of the global equity opportunity set outside the U.S. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The Russell 2000 Index is a well-known, unmanaged index of the prices of 2000 small-cap company common stocks, selected by Russell. The Russell 2000 Index assumes reinvestment of dividends but does not reflect advisory fees. An investor cannot invest directly in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The S&P Mid Cap 400 provides investors with a benchmark for mid-sized companies. The index, which is distinct from the large-cap S&P 500, is designed to measure the performance of 400 mid-sized companies, reflecting the distinctive risk and return characteristics of this market segment.

The S&P 500 Pure Value index is a style-concentrated index designed to track the performance of stocks that exhibit the strongest value characteristics by using a style-attractiveness-weighting scheme. An investor cannot directly invest in an index. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor.

The CBOE Volatility Index (VIX) is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500 Index call and put options. On a global basis, it is one of the most recognized measures of volatility -- widely reported by financial media and closely followed by a variety of market participants as a daily market indicator. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor. An investor cannot invest directly in an index.
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