Big changes in smaller stocks create new mid-cap opportunities

Index changes challenge the notion of passive investing

In a strict sense, there’s no such thing as truly passive investing. The makeup of equity market indexes is constantly in flux as performance varies across sectors, small and large market capitalizations, and other market dimensions, including the individual security level. In response, index providers routinely adjust index composition to more accurately represent an asset class’s current breadth. However, investments that seek to passively track those indexes aren’t precise mirror images of them on a constant basis; there’s lag time before index-tracking investments adjust holdings to reflect their benchmarks in an ever-changing environment. When markets make big moves, significant differences can emerge between indexes and passive investments.

There can also be large variances across market segments, such as instances when large caps have significantly larger or smaller weightings in specific sectors than their smaller peers. These differences can affect diversification potential, depending on how much exposure a portfolio has to each area. For active investors, these differences can create investment opportunities, leaving some benchmarks with sizable exposure to market segments that may have recently become either over- or undervalued relative to other areas.

Mid caps and the benchmark composition opportunity

We’re mindful of these opportunities as we consider that U.S. large-cap stocks’ positive performance through the first half of 2023 was largely driven by just a handful of technology companies, resulting in growing tech weightings in large-cap indexes.

Moving down the market capitalization spectrum to mid caps and small caps, we see much smaller relative weightings in tech and much larger ones in industrials, a sector where we currently see strong potential. In fact, tech and industrials are currently the two sectors with the largest differentials between mid- and small-cap stocks versus large caps. Consider that the industrials weighting in the Russell Midcap Index (Russell Midcap) was 21.7% as of August 31, 2023, and 18.5% in a small-cap benchmark, the Russell 2000 Index (Russell 2000), versus just 12.8% in the Russell 1000 Index (Russell 1000). In contrast, the latter index—a large-cap benchmark—had a hefty 30.9% in technology versus 13.0% for the Russell Midcap and 13.2% for the Russell 2000.

Source: FTSE Russell, as of 8/31/23. The Russell 2000 Index tracks the performance of 2,000 publicly traded small-cap companies in the United States. The Russell Midcap Index tracks the performance of approximately 800 publicly traded mid-cap companies in the United States.  The Russell 1000 Index tracks the performance of 1,000 publicly traded large-cap companies in the United States. It is not possible to invest directly in an index. 

Why differences in market index sector weightings matter so much now

For us, these gaps are particularly meaningful, as we currently have a favorable view of mid caps and industrials, which has the highest weighting among 11 sectors in the Russell Midcap. Our view stems in part from a key investment theme that we’ve been focusing on this year: the build-out of U.S. manufacturing capabilities and the potential that it has created in industrials.

The ramp-up in this capacity is in part the result of recent U.S. government stimulus spending, including the $1 trillion Infrastructure Investment and Jobs Act, the nearly $400 billion in clean energy spending in the Inflation Reduction Act,  and the $280 billion CHIPS and Science Act to boost the domestic chip-making industry and scientific research. This spending will continue for several years, bringing growth to the Upper Midwest as well as other industrial hubs across the nation. Much of the spending targets semiconductors and electric vehicle (EV) manufacturing; from 2020 to 2022, business investment in semiconductor projects totaled $192 billion and EV projects $40 billion, according to the U.S. Economic Development Administration. Those investments are projected to create a total of 62,000 jobs.

Furthermore, China has recently become less competitive on these fronts, and businesses have increasingly chosen to expand industrial manufacturing in the United States or Mexico—a trend known as onshoring, or reshoring.

Mid caps and the quality factor

While the Russell 2000 also has a large weighting in industrials relative to its large-cap peers, we view mid caps more favorably than small caps. One key reason is that, relative to mid caps, there’s currently a relatively modest number of smaller companies that currently possess quality characteristics, in our view. Among those characteristics are strong balance sheets, more durable profitability, higher return on equity, and less need for capital in a period of higher borrowing costs. We view such characteristics as vitally important given today’s environment of slowing growth and recessionary risks, and we generally prefer mid caps as an opportunity to pursue current exposure to industrials. In addition to their relatively high weightings in industrials and the quality factor, mid caps offer exposure to a different growth driver than large caps, given the latter category’s recently expanded weighting in the largest tech stocks.

Mid caps’ attractive valuations

Furthermore, we currently view mid caps as attractively valued based both on a historical price-to-earnings ratio basis and relative to large caps. In fact, as of August 31, 2023, the S&P MidCap 400 Index was trading at 13.8x forward earnings—well below its long-term average of 15.8x, according to FactSet. In contrast, the S&P 500 Index was trading at 18.9x, well above its 20-year average of 15.6x. Based on those numbers, mid caps were trading at about a 27% discount to large caps, a relative value not seen since 1999.

Source: FactSet, as of 8/31/23. 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. The forward price-to-earnings (P/E) ratio is a stock valuation measure comparing the current share price of a stock with the underlying company’s estimated earnings per share over the next 12 months. Past performance does not guarantee future results.  

Positioning for the market ahead

While the economic environment is likely to remain challenging for equities, we think that 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 economy tips into a recession and market volatility rises.