The past five years have painted an intriguing picture for equity investors.
While U.S. large-cap stocks have outperformed their smaller counterparts, beneath the surface lies a surprisingly different dynamic: Earnings growth for small- and mid-cap companies has outpaced that of large-caps.
So what’s fueled large-cap stock performance? Greater premiums on their earnings.
Gains—and Risks—Increasingly Concentrated
While the large-cap return data is impressive, one caveat is that a handful of stocks account for an outsized portion of the performance.
The so-called “Magnificent Seven,” growthy, artificial intelligence (AI)-connected names that dominated markets through 2023, represented approximately 28% of the S&P 500 Index market cap at year end and drove roughly two-thirds of its overall full-year returns. That dominance also extended to the ACWI, where the Magnificent Seven held a significant 16.9% weighting in the index, which has 2,900 other constituents, and contributed nearly 40% to its total return.
More broadly, U.S. companies represented close to 63% of the total market capitalization of the MSCI All Country World Index (ACWI).
Meanwhile, valuation spreads between the leaders and the rest—both U.S. vs. non-U.S. stocks and large cap vs. smaller cap—have widened considerably.
We contend that investors may not fully grasp the extent to which concentration and concentration risk have intensifiedin broadly followed indexes. We believe many investors are overly exposed to the U.S. market and to large-cap stocks,highlighting the need to diversify into non-U.S. markets and small- and mid-cap equities.
We also assert that global small- and mid-cap equity markets present compelling opportunities, particularly given historical trends and the current macroeconomic landscape: These markets appear relatively undervalued and offer ripe prospects for investors.
What’s the Problem?
The U.S. weight in the ACWI index is more than twice the U.S. share of global GDP, which the World Bank places near 25%.
Meanwhile, at the individual level, U.S.-based mutual fund investors held 23.8% of their equity fund allocation in overseas investments as of mid-2023.
To us, the U.S. market feels both top-heavy compared to the rest of the world, and we believe the gap between U.S. and non-U.S. markets will likely narrow over time.
Markets are generally cyclical, and currencies fluctuate. It may be hard to imagine today, but over the last 50 years—including 2003-07, when emerging markets led the charge—stocks outside the U.S. have outperformed by a wide margin over significant periods. The current U.S. run, in terms of trailing 12-month returns, isn’t totally uninterrupted, but it’s the longest cycle in either direction since 1970.
Valuation Differentials Can Create Opportunities
U.S. stocks tend to trade at a premium to international equities, due largely to the nation’s growth orientation and scope, as well as the profitability and quality of some of the world’s largest companies.
Source: Fikon and AZTLAN Equity Management as of 1/30/2024
Top Decile International SMID Stocks
However, the valuation gap has expanded rapidly in recent years and started 2024 at its largest spread in 20 years. Specifically, the S&P 500 Index’s P/E ratio was hovering near 20, far from its long-term average of 15.6, while the MSCI ACWI ex U.S. Index P/E ratio sat at 12.8, trailing its long-term average of 13.5.
Source: Mission Wealth, Q2 2023 Market Perspectives
The difference is similarly stark when looking at small-cap equities. As of December 31, 2023, the MSCI ACWI ex USA Small Cap Index traded at a forward P/E ratio of 12.87, versus the MSCI USA Small Cap’s 19.02. Furthermore, the MSCI ACWI ex-USA SMID Cap Index forward P/E ratio was 13.11, lagging the 18.58 recorded by the MSCI USA SMID Cap Index.
Regardless of where you focus on the capitalization spectrum, the valuation difference between the U.S. and the rest of the world is significant.
The Case for International Small Cap
The choice to invest in smaller international stocks should not hinge solely on relatively lower valuations, although those do offer a measure of support.
Trends—even very powerful, long-term trends—tend to even out over time. We believe the broad opportunity set for SMID caps in both developed international and emerging markets is huge for many more reasons:
- We believe much of the U.S.’s outperformance since the GFC is tied to monetary policy, which was historically loose, led by the U.S. Federal Reserve’s near-zero interest rates and massive bond purchases. As Fed officials have spent the last 18 months unwinding those moves, the tailwinds that supported growth-oriented consumer discretionary and technology sectors that helped fuel U.S. dominance are poised to weaken.
- In our view, international small caps are much more diversified than their U.S. peers, because they tend to have exposure to multiple markets. More specifically, when a company grows from a smaller economy, it must become international quicker than a U.S. firm.
- In part because SMID caps draw less analyst and media coverage, we believe that smaller‐cap markets tend to be less efficient than their large‐cap counterparts. As such, we believe the asset class offers more potential to add value through stock selection.
A More Thoughtful Way to Proceed
Ultimately, we believe that small- and mid-cap stocks, in both developed and emerging markets, deserve a solid presence in a well-diversified portfolio.
Whether an investor is based in the U.S.— or elsewhere—it’s likely they have considerable exposure to U.S. large-cap stocks due to their sharp relative outperformance in recent years.
Adding smaller stocks in a variety of markets—including the U.S.—offers diversification benefits. But the story, in our minds, is equally—if not more—about broadening the investment opportunity set.
Indexing and passive investments have historically helped broaden a portfolio’s horizons, both geographically and in market capitalization.
And yet, passive indexes are not designed to identify the best opportunities, especially in markets where information, transparency, and even access can be limited. That’s where active management offers value, because the right team can help navigate key challenges, from changing regulatory environments and fluctuating currencies to political and economic uncertainty and language barriers.
At AZTLAN, we combine proprietary quantitative screening and intensive fundamental research, analysis, and valuationassessments to provide exposure to what we believe are unique, smaller-stock opportunities worldwide.
Additionally, we believe stepping away from the indexes and their biases is essential for investors to achieve their comprehensive diversification objectives.
