High-Quality Small/Midcap Stocks Likely to Fare Well in Volatile Markets
What We Are Seeing
To paraphrase Mark Twain, reports of the death of high-quality stocks have been greatly exaggerated. Years of fiscal bailouts and an implicit "Fed Put" led many equity investors to abandon high-quality investing to chase more speculative, higher-risk securities. Companies with durable and growing earnings and cash flow became passé, as investors flocked to SPACs, meme stocks, crypto and prospects of future growth at any valuation.3 Fads always end—you just never know how or when.
We are glad but not surprised to see high-quality equities performing well, as they have in past market declines. We expect high quality will continue to add value if market volatility persists into 2023, which we believe is likely.
We see early signs of a leadership change. Yesterday's winners (momentum, long duration, unprofitable companies, etc.) will probably not be tomorrow's leaders. Looking back at the Nifty 50 and dot-com periods, those leaders turned into laggards for a full decade following their pinnacles.
We think we may be in the early days of a shift in leadership from new economy to old economy. Future corporate spending will likely be focused on reshoring or nearshoring, and stock market investors may place more emphasis on earnings and cash flow.
Valuations of small/midcap stocks overall are more attractive than large/megacap. Since their recent market peak in November 2021, small/midcap stocks have underperformed large/megacap, creating an attractive relative valuation opportunity.4
Large/megacap companies, which typically have more exposure to non-U.S. revenues, could experience ongoing volatility as global economies are more exposed to recession, inflation, weakening currencies and geopolitical risk. We see the trend to corporate reshoring as having an outsized benefit for small/midcap company revenue and earnings.
What We Are Doing
Staying true to our high-quality investment process. While market conditions change over time, we believe that high-quality investing leads to long-term outperformance with lower volatility and risk.
Biding our time. We are traditionally known as a low-turnover manager. Our goal is to identify great businesses, buy them at attractive valuations and then let those management teams create value for our clients. While great companies are always on our research list, they may not always be trading at attractive entry points. So patience is a virtue.
Ready to take advantage of shifting conditions. As market expectations and valuations reset, we think buying opportunities will expand.
What We Are Watching
Company management teams' matter to us. As a fundamental, bottom-up manager, we spend little time following or forecasting macroeconomic conditions. Instead, we spend significant time with company management to better understand their specific financial, operational and managerial strengths and weaknesses.
We find one of the biggest determinants for a company's long-term success is disciplined capital allocation. Challenging economic times like these can shine a light on those teams that are "best of breed."
Our goal is to find and invest in a select number of high-quality companies built to withstand—and even take advantage of—the volatility associated with periods of uncertainty.
Reshoring and nearshoring trends may play a particularly material role in the industrial sector, where we have an overweight position, as well as for small/midcap companies generally.
Chip Reed, CFA
Portfolio Manager
Core Equity, Atlanta Capital
The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.
1Higher-quality companies typically have consistent earnings, strong balance sheets, significant free cash flow generation, growing revenues and meaningful competitive advantages, whereas the opposite is true for their lower-quality counterparts.
2 Reshoring refers to returning the manufacturing and production of goods from a foreign country back to the company's original country. Nearshoring occurs when a company transfers work to another organization within its own region.
3 SPAC, or special purpose acquisition company, is a publicly traded company created for the purpose of acquiring or merging with an existing company. Meme stocks are shares that have gone viral because of their popularity on the internet, especially in social media discussions.
4 Source: Morningstar Direct, November 1, 2021 to November 30, 2022. Small-cap stocks are represented by the Russell 2000, small/midcap stocks by the Russell 2500, large-cap stocks by the Russell 1000 and megacap by the Russell Top 200.
Russell 1000® Growth Index is an unmanaged index of U.S. large cap growth stocks.
Russell 1000® Index is an unmanaged index of 1,000 U.S. large‑cap stocks.
Russell 2000® Index is an unmanaged index of 2,000 U.S. small‑cap stocks.
Russell 2500® Index is an unmanaged index of approximately 2,500 U.S. small-cap and midcap stocks.
Russell Top 200 Index measures the performance of the 200 largest companies in the Russell 1000 Index.
