With megacaps dominating during the rally, Julian Howard argues that overlooked US mid-cap stocks now offer compelling fundamentals, including valuations and the sector make-up amid a booming US economy. Technology still has its place, but investors could benefit from a broader US equity mix.
05 August 2024
1960s pop music trailblazers The Beatles were famously dominated by the Lennon-McCartney songwriting partnership, and of course the accolades were richly deserved. But the quieter writing partner was of course George Harrison, whose contribution may have been less high profile but still yielded legendary work including Here Comes the Sun and While My Guitar Gently Weeps. In a similar vein, US stocks have been dominated of late by the megacaps and in particular technology stocks including the so-called “Magnificent Seven”, to the seeming exclusion of everything else. The case for US megacaps remains strong, and right now rests on the persuasive idea of supplying a societal technology revolution driven by Artificial Intelligence (AI). This secular case is not about to go away anytime soon and readers looking for an excuse to dump all their US large cap holdings to take immediate profits will find no encouragement here. Instead, there is a case for an accommodation that can tap into the potential broadening of equity market leadership. Just as with The Beatles and other great bands, markets are not always about one or two high-profile driving forces, and there is often space for other areas to thrive simultaneously. Enter then US mid-cap stocks.
The valuation case for mid-caps
For convenience, the S&P 400 Index provides a reasonable proxy for this part of the equity market, with the average constituent having a market cap of USD 5.8 billion1 compared with USD 71.8 billion1 for the S&P 500 and USD 2.9 billion1 for the Russell 2000 small cap index, according to S&P and FTSE Russell respectively. The names in the mid-cap segment may not be as familiar as Microsoft or Coca-Cola but are still solid, recognisable businesses such as Alcoa, Under Armour and Mattel. While dedicated stockpickers will see opportunities within this (only very) slightly less liquid and well-known part of the US equity landscape, the US mid-cap arena is, in our view, most appealing at the aggregate level for a number of reasons. Firstly, the S&P 400 offers better value than the S&P 500, trading at 18.0x forward price/earnings2 as at 24th July when compared with the S&P 500, which is trading at 23.0x1. The S&P 400 is therefore trading at a discount of nearly 23%3 versus US large caps, with the average discount since 1995 in fact being no discount at all, but a very small premium. While there is no law of investments that says that today’s discount must one day close - Europe’s versus the US never seems to - it does mean that mid-caps have theoretically more potential to perform well than large caps from here, should the right catalysts present themselves. For some, an even more convincing way to look at mid-caps is through the prism of their relative yields. The S&P 400 enjoys an effective forward earnings yield of 5.6%4 as of 24th July, compared with the S&P 500’s 4.3%, which itself is barely more than the 4.2% yield1 offered by the 10-year US Treasury note, an instrument widely regarded as guaranteed, with virtually no risk of the US Treasury defaulting on its obligations.
Sector diversification matters when the chips are down
Looking at the underlying sector mix, US mid-caps also appear more evenly balanced than the S&P 500. Broad technology stocks make up fully a third of the S&P 500, but just 12%1 in the S&P 400. There is of course much to admire about technology companies and their long-term ability to monetise innovation, but investors looking to diversify their US equity exposure slightly in favour of today’s thriving US real economy may appreciate US mid-caps’ higher allocations to more domestically focused sectors, such as consumer discretionary and industrials as well as real estate.
Discounted diversification - US mid-caps trading significantly cheaper than large caps:
From 31 Jan 1995 to 24 Jul 2024
![](https://cdn.gam.com/-/media/content/insights/investment-opinions/images-2024/hey-shrewd-why-us-equity-portfolios-should-emulate-the-beatles/chart-1.png?modified=20240801141241&rev=-1&hash=429BA4935B00F8B8CD5F9BBC592164CE)
Source: Bloomberg
What could shine the performance spotlight on mid-caps?
With the underlying case laid out, what then would the catalysts be for strong relative US mid-cap equity performance from here? Their exposure to domestically orientated stocks points to US economic growth being an important driver for their earnings. And the good news is that the US economy has been booming of late, driven by government programmes such as the CHIPS & Science Act and the Inflation Reduction Act, as well as consumer spending driven in part by pandemic stimulus cheques. The US presidential election is unlikely to see this largesse reversed, with neither party focusing on reining in the (admittedly sizeable at -5.6%1) US budget deficit. As such, tax cuts under a second Trump term or further stimulus initiatives under a potential Harris administration should support continued consumer confidence and therefore economic growth, albeit not quite at the pace seen this year. The Bloomberg survey of economists highlights America’s still-favourable growth pathway, with a consensus growth rate for the US of 2.3% for 2024, 1.8% for 2025 and 2.0%*1 in 2026. Compare this with say the eurozone, with its respective 0.7%, 1.4% and 1.3%*1 growth rate forecasts.
Mid-caps should see outsized benefits from rate cuts
Then there is arguably the potential start of a US monetary policy easing cycle to look forward to. With inflation now down to 3.0%, the case for the Federal Reserve cutting rates from the current 5.25%1 upper bound will become harder to resist. This is not least because keeping rates where they are as inflation cools automatically raises real rates and acts as an ever-harder brake on the economy. If and when interest rates do come down, US mid-cap stocks should disproportionately benefit given that they are more closely connected to the US real economy and consumer than the S&P 500, per the sector point above. They could also enjoy outperformance as rates come down since the relative advantage of the megacaps’ huge cash piles (a cool USD 108 billion in the case of Google parent Alphabet5) will become less important. Finally, and without detracting from the long-term case for megacaps, some profit-taking in the large tech firms could also see money looking for a fresh ‘story’ to buy into. The choppier performance of both the Nasdaq and the S&P 500 Index since mid-June suggests some investors may be re-assessing their broader US allocations, with mid-caps one of the potential beneficiaries.
The right sensitivity, right now – US mid-cap earnings’ are closely linked with US economic growth:
From 31 Mar 1996 to 31 Mar 2024
![](https://cdn.gam.com/-/media/content/insights/investment-opinions/images-2024/hey-shrewd-why-us-equity-portfolios-should-emulate-the-beatles/chart-2.png?modified=20240801141241&rev=-1&hash=C2396796FCF003A63C3A3738E7193643)
Source: Bloomberg
EPS = Earnings per Share
The era of large cap dominance of US - and indeed global - equities may or may not end in 2024 but the case for other sectors of the markets to thrive independently is becoming more convincing. US mid-caps offer compelling valuations and a well-diversified, economically correlated sector mix as a solid starting point. Combine with today’s circumstances of a strong US economy, the (eventual) prospect of lower rates and some signs of measured profit-taking in this year’s US equity winners and the rationale for a broader US equity allocation that includes US mid-caps - even if only via a simple index exposure - becomes more appealing. In groups of all kinds, to achieve great things every member has to pull their weight and play their part in the performance. George Harrison might have been overshadowed by the bigger personalities of Lennon and McCartney but The Beatles would have been much the poorer without him.
2Also known as forward P/E, this reflects and average of index constituents’ share prices dividend by consensus forecast of their future earnings. This is a predication and there is no guarantee than the forecasts will be realised.
318x relative to 23x, suggesting (but not guaranteeing) that mid-caps could by 23% cheaper than large caps, should these forecasts turn out to be accurate.
4This represents a comparison of consensus forecasts related to yields, typically from dividend payouts, by companies in future, relative to their share prices. These forecasts are predictions, are not guaranteed and may not turn out to be accurate.
5As at 31 March 2024, cash, cash equivalents and marketable securities, such as short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. https://abc.xyz/2024-q1-earnings-call/
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