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Why U.S. Small- and Mid-Cap Equities Now?
By: Rob Lanphier, Tara Patock, Aaron Socker, and Aden Gebeyehu, William Blair
We believe the rationale for investors to look favorably on U.S. small- to mid-cap (SMID) equities has been building for several years, but as we have been reminded, relative valuation in comparison to large caps is not necessarily sufficient. In this article, we observe several factors that may already have begun to attract investor attention.
This is an excerpt from NCPERS Winter 2025 issue of PERSist.
We believe the rationale for investors to look favorably on U.S. small- to mid-cap (SMID) equities has been building for several years, but as we have been reminded, relative valuation in comparison to large caps is not necessarily sufficient. Below we observe several factors that may already have begun to attract investor attention.
Market Leadership May Be Shifting
Stepping back and looking at nearly a century of market performance, it is clear that there are distinct periods of underperformance and outperformance for U.S. smaller- and larger-cap companies. For the last 13-plus years (from 1/1/2011 to 9/30/2024), larger caps have dominated.
U.S. SMID-Cap Valuations Are at Generational Lows
From a relative valuation perspective, the disparity between U.S. SMID-cap and large-cap companies has continued to grow. Today, U.S. SMID caps are at generational lows from a forward price-to-earnings (P/E) perspective, as demonstrated by their 38-year history.
Expected Earnings Growth for U.S. SMID Caps Has Improved Materially
From a fundamental perspective, Wall Street analysts anticipate stronger small-cap growth in 2025 for the first time in several years. Compelling valuations and stronger fundamentals could provide a meaningful tailwind for this asset class.
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U.S. SMID Caps Have Historically Outperformed After U.S. Rate Cuts and Recessions
Looking at historical market behavior, U.S. smaller-cap equities have generally outperformed after a first rate cut by the U.S. Federal Reserve or an actual recession in the United States.
M&A Activity Could Tip the Scales in Favor of U.S. SMID Caps
Mergers and acquisitions (M&A) transaction volume was strong in 2024, and that is often a signal for smaller-cap investors, because Wall Street can pick up on what large-cap companies are viewing as attractively valued assets.
Onshoring Could Benefit U.S. SMID Caps
The secular onshoring trend has continued, with more U.S. multinationals bringing their products, services, and intellectual property back to the United States given heightened tariffs, supply-chain disruptions, and geopolitical tensions globally. This has created an unusual opportunity for smaller, more U.S.-centric (local) companies to benefit as jobs, infrastructure, and economic stimulus broadly from secular capital inflows.
In Conclusion
In summary, there is no perfect method for calling the timing of the market's potential pivot toward non-large equities. We would advocate for investors to consider combining an asset allocation of large caps with a non-large portfolio. However, over the last few months SMID caps have begun to outperform. From July 11, 2024, when U.S. Federal Reserve Chairman Jerome Powell pivoted his language from rate tightening to cutting, through the end of September, the Russell 2000 Growth Index has outperformed the Russell 1000 Growth Index by 961 basis points.1 While too soon to suggest that a pivot to non-large-cap equities has started in earnest, we strongly believe it's a solid step in the right direction.
Endnotes:
1 From 7/11/24 to 9/30/2024, the Russell 2000 Growth Index returned 7.92% and the Russell 1000 Growth Index returned -1.69%.
Bios: Rob Lanphier, partner; Tara Patock, partner; Aaron Socker; and Aden Gebeyehu are portfolio specialists for William Blair's U.S. growth and core equity strategies.
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