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