Managing valuation and quality risk with mid caps
Amid a choppy macroeconomic backdrop, allocating to mid-cap equities can help manage valuation risk and quality risk within portfolios.
The macroeconomic backdrop has been variable, making it difficult for investors to position their portfolios for macro trends. In times like these, investors can often get whipsawed as intra-equity leadership within the market rotates. In our view, there are two main risks to focus on managing from an equity perspective: valuation risk and quality/solvency risk. We believe that these risks are important because current elevated valuations will likely weigh on longer-term return potential and higher interest rates will make it difficult for lower-quality or smaller companies to sustain themselves.
Decreasing valuation risk
Mid-cap equities are currently trading at a discount relative to large-cap equities, providing one way for investors to reduce the valuation risk within their portfolios. Historically, the forward price-to-earnings (P/E) ratios for both large- and mid-cap equities have tended to reflect similar multiples, with the ratio of the two P/Es averaging 1.00. However, valuations for mid-cap equities now appear relatively cheap when compared to large caps.
The valuation advantage for mid-cap equities
Forward P/E of mid caps relative to large caps
Source: FactSet, as of 1/31/23. Mid caps are represented by the S&P MidCap 400 Index and large caps are represented by the S&P 500 Index. The S&P MidCap 400 Index tracks the performance of 400 mid-cap publicly traded companies in the United States. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Last September, the ratio fell to 0.72, meaning that mid caps were trading at a 28% discount to large-cap equities. The only other time in recent history when mid-cap equities have traded at such a deep discount to large caps was just before the tech bubble burst; that low-water mark occurred in March 1999, and over the next seven years, mid caps went on to outperform large caps by 124%.
Recent market performance has slightly narrowed this valuation gap but still shows mid caps trading at a 21% discount to large-cap equities. And though past performance is no guarantee of future returns, we do see some similarities between the recent market environment and the tech bubble. Over the past few years, certain areas of the market such as SPACs, meme stocks, and NFTs have seen valuations that weren’t supported by the underlying fundamentals. As the market shifts back to rewarding high-quality, profitable companies, we believe that this historic valuation advantage could provide support for mid-cap equities in the months ahead.
Keeping quality in mind
On an absolute basis, small-cap equity valuations also look attractively valued but overall aren’t much cheaper than mid-cap equities. In addition, small-cap indexes like the Russell 2000 Index can have significant solvency risk. Roughly 40.0% of companies included within the Russell 2000 Index were unprofitable last year. These small-cap companies also tend to have lower return on equity (ROE), another measure of quality. The average ROE is 6.5% for the Russell 2000 Index compared to 17.4% for the Russell Midcap Index, according to data from FactSet.
With the potential for a recession looming on the horizon and businesses facing a higher cost of capital, we prefer mid caps to small caps due to their higher quality, mitigating the exposure to businesses with low or no profitability.
Sector tailwinds to provide a boost
Looking ahead, we see longer-term positive catalysts that could provide support for mid-cap equities as well. Disruptions in the global supply chain brought on by the COVID-19 pandemic have incentivized many large U.S. companies to begin reshoring jobs, many of which have landed throughout the Midwest. This influx of jobs and capital should help provide a boost both to local economies and the industrials sector overall.
Industrials remains one of the largest sectors within the mid-cap space, making up nearly 20% of the asset class. Mid-cap industrials comprise a diverse group of industries, ranging from industrial machinery to engineering to electronics. These industries are likely to be the areas that benefit most from this reshoring megatrend that could persist for years, creating a secular tailwind for the industrials sector, and in turn, mid-cap equities.
Positioning for the market ahead
While the economic environment is likely to remain challenging for equities, we think investors can prepare by positioning their portfolios for continued market volatility. Having a tactical tilt toward mid-cap equities can provide a complement to large-cap exposure, decreasing valuation risk while maintaining exposure to high-quality names that should hold up if the market tips into a recession.
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