Senior portfolio manager puts forward the case for small and mid-caps
Small and mid-cap stocks hold a distinct edge over large-cap companies, according to Owen Gibbons, who argues some of the “Magnificent seven” could be destined to fall.
The senior portfolio manager and partner at Van Berkom Global Asset Management believes it’s a big negative to have a significant concentration at the top end of your index because you’re held hostage to the fortunes of a smaller group of companies. He believes institutional investors need to be more wary of that cohort led by Nvidia, Apple, Amazon, Alphabet, Meta, Tesla, and Microsoft.
“After a couple of years of extraordinarily strong performance from these stocks… to me, mean reversion is a big factor in markets,” he said. “I just don't see these stocks continuing to grow and grow.”
So, what’s so attractive about these smaller assets? Essentially, the small and mid-cap space offers better diversification. In the small-cap segment, Gibbons explained, the top-performing stocks account for a much smaller share of the overall index, providing more balanced opportunities for investors. Many of these companies are either market share gainers or operate in niche markets, allowing them to potentially deliver double-digit earnings growth over a 5 to 10-year period.
“Our view is small cap is a much more diversified index right now,” Gibbons said. Small-cap stocks also provide fertile ground for identifying growth prospects. For instance, small caps are either the ones that own a very niche market, but the market won’t be very big; or, as Gibbons described, “the challengers and the market share gainers.”
“They're the ones who’re investing heavily today. They're growing much faster than the overall market, and in many cases, you might have a decade of double-digit growth in these businesses,” Gibbons explained. He emphasizes small caps are what Van Berkom pays the most attention to because they’re the more attractive, with an ability to scale and grow from an earnings perspective.
Additionally, a lot of them are not that expensive “because they're under followed and under watched,” noted Gibbons.
Consequently, mid-cap stocks can be the “best of both worlds”. "They might not be number one but they’re the most significant challengers to large-cap companies. They’re inherently more stable and corporatized but still have room for improvement in margins,” added Gibbons.
Large cap companies, in comparison, are typically global titans who own the market, explained Gibbons and unless that market is growing 20 per cent, many of them are “GDP plus a bit,” resulting in overall growth plus a bit of margin enhancement.
“Effectively, average large cap companies don’t grow earnings much more than 10 per cent a year, unless they're buying back a lot of their stock. Fundamentally, their growth outlook is very stable, but quite low,” highlighted Gibbons.
He pointed to concentration in large cap indices as a key factor limiting broader performance, highlighting the top 10 per cent of the S&P 500 is 37 per cent of the index weight, while the top 14 are 40 per cent. “It gets into this mentality of only 15 stocks matter out of 500,” he said. Contrastingly, the small and mid-cap market offers greater diversification, with the top 14 stocks in the small-cap Russell 2000 index accounting for just 17 per cent of the benchmark.
However, because Van Berkom’s strategy leans towards US small and mid-cap equities, Canadian institutional investors face a few challenges for Canadian small caps. Andy Kong, head of global business development at Van Berkom, explained the S&P TSX small cap index is heavily weighted towards the energy and materials sectors, which can be volatile and dependent on commodity prices.
This sector concentration can lead to significant swings in the performance of the overall Canadian small cap index, making it challenging to generate consistent returns.
“The biggest factor for our Canadian small cap product is the fact that they really have de minimis energy and material exposure, which is around 40 per cent of their index. These companies don't earn good returns in capital. Our Canadian product will have periods of wildly different returns versus the [US] benchmark,” noted Gibbons.
Additionally, unlike US small caps, which are largely domestic investments, Canadian small cap companies tend to be more globalized, with international operations and supply chains. This makes them more susceptible to global factors, such as tariffs, which could have a significant impact on Canadian small caps since many of these companies sell their products globally and rely on cross-border supply chains.
Gibbons points to “old Warren Buffet” to make his case. “If you compound in these names [small and mid-caps] over a few decades, you tend to make very good returns, and by the time they're large cap, the best returns have already happened, albeit at a much lower risk part of your return cycle. But you're not going to make the same amount of money,” he said.
“That’s why there’s good value in both small cap and in mid cap; they’re either creating new products or taking market share. That's the attractiveness of getting in these names much earlier,” added Gibbons.
