The rise of passive investing continues to result in large-cap concentration on the buyside. Cost pressures continue driving sellside firms to cut coverage of small and mid-cap stocks that many might consider less likely to become income-generators. With MiFID II ahead, the trends seem unlikely to change for quite some time.
But there can be massive takeout premiums for small and mid-cap names in the market. Simply put, there is considerable and ever-increasing value in considering small and mid-cap stocks that many investors routinely ignore. Low interest rates and easy credit simply wouldnt explain the positive performance.
However, the question remains. How do you access the information and mine the data for gems? The strategy demands access to a database with a massive breadth of coverage, including the usual and larger stocks, as well as the small and mid-cap space that is too often overlooked.
In this eBook, we will consider the missed opportunities for analysts, portfolio managers, directors of research, founders and CIOs in small and mid-cap stocks. Admittedly, it takes skill and discipline to identify underfollowed small and mid-cap names that are likely to outperform, but the effort may prove worthwhile.
An Active Approach
The argument for passive investing through index funds and ETFs reflects conventional wisdom. Index funds carry smaller fees, and ETFs provide tax efficiency, as well as lower operating costs. Thats been bolstered by a period of historically low interest rates since the 2008 financial crisis. However, the strategy may be a bit myopic in a time when stock correlations are weakening in a more volatile market. Small and mid-cap stocks have a place in a portfolio, along with risk-based allocation.
We can point to central bank intervention post-financial crisis for the flows to passive investments, but over the long haul, active investing still wins the day. Active investors are also set to benefit from rising interest rates and increasing volatility.
Today, active portfolios remain the bulk of assets, despite the outflows during the past few years. Total assets of actively managed funds totaled $11.4 trillion vs. $6.7 trillion for passive funds in 2017. Indeed, some would argue that active investing is slowly making a comeback and that the large outflows of 2015 and 2016 are sure to subside.
There are signals that this could be the case. While passive investments continued to see a record level of inflows, Morningstar indicates active funds were close to breaking even in 2017. The performance of active managers is improving, which is a good sign, due in part to a drop in stock correlations.
So, when is the right time to position yourself for the potential reversal? Value investors make the case for tirelessly looking for stocks that the market has undervalued.
An equity research data provider, offering sweeping coverage of American equities, provides the ability to consistently search for the value in the small and mid-cap world. With deep coverage of North American companies, including ones with little to no coverage by the Street, its certainly possible to find hidden gems-equities that the market has mispriced.
Undervalued Names & Abnormal Returns
The costs of coverage, in addition to shrinking trading desk staff, placed tremendous pressure on the sellside. It was inevitable that many small and mid-cap names lost coverage.
Market conditions also indicated a major shift in investing patterns. The rise of passive investing, in turn, resulted in large-cap concentration on the buyside. As passive investments become the safe haven, the value gap between large vs. small and mid-cap keeps growing. The chance for arbing the gap is there.
For the disciplined analyst or PM, a smaller and undervalued stock, when well-picked, may represent outsized growth potential. The evidence bears it out. Of the first analyst coverage of 549 neglected stocks that publicly traded at least one year without any research coverage, the stocks saw a +4.86% abnormal return at the initiation announcement. The key is in identifying small and mid-cap stocks early on to benefit when the market will eventually take notice and start coverage. Fundamental research is the only way to do just that.
In summary, company size neednt be the only measure of value. When well researched, small and mid-cap stocks can present a huge growth potential. The lack of analyst coverage makes the probability of mispricing great. This presents an opportunity for those willing to do the legwork by sifting through the best research provided by leading-edge data providers, then digging deep into company fundamentals..
So, when is the right time for small and mid-cap stocks? The time is now. The financial market is normalizing. Plus, many should remember that, over the long-term, small and mid-caps have outperformed large-cap stocks.
Its also smart to consider the pool of alpha theory. We can attribute the performance decline from equity hedge funds since 2000 to the theory-too many funds chasing the same trades. Its inevitable that the weaker players will be forced out of the market, improving returns over time, and, consequently, the opportunities for stock picking.
The lesson is this. Theres considerable value in finding new products to head off that pressure, especially as decreasing service levels from the sell side occur. Buysiders are beginning to recognize the value of adopting technology solutions to facilitate financial analysis.
AI, big data and risk analytics may have their place. But theres still a major case to be made for data providers who can offer specifics on company fundamentals, whether its historical financials, operating and segment data, valuation metrics, major corporate events and live pricing.
Data providers allow analysts, PMs and directors of research the ability to leverage the latest technology and concentrate efforts on higher-value activities. Startup funds can particularly benefit by reducing reliance on the sell side, enjoying considerable cost-savings along the way.
Excel-based data provides for the ability to create handpicked information and do sector analysis, providing consistency of that same data. As tech innovation accelerates, its clear that the right tools can help identify the signals to increase returns.
James Rife is Head of Equities & Co-Founder of Canalyst
