SMID-Cap Rally Has More Runway

Bruce Aronow

After the eye-popping outperformance of US small- and mid-cap (SMID) stocks this year, investors are asking why they should buy them now. We say, why not?

Doubters assume that these stocks are headed for a fall, but that’s far from inevitable. Excluding this year, there have been seven occasions since its 1986 inception that the Russell 2500 Growth Index (the proxy for SMID-cap growth stocks) has risen by 25% or more in the first three quarters of the year. On average for all seven periods, it was down 2.2% 12 months later. But, in four of those seven years, the index was higher 12 months later, by an average of 11.6%. We don’t see much predictive value in these past results.

It’s better to look at the traditional underlying drivers of small-company stock performance. Though these stocks aren’t cheap, they aren’t excessively expensive either, trading at above-average valuations versus their own history and relative to large-caps. But with earnings growth looking poised to accelerate, and interest rates likely to stay low for some time, we think SMID-caps can continue their upward march, even if there’s some valuation compression.

History suggests that consistent, long-term exposure to smaller-cap stocks is almost always a good idea—even if an investor badly bungles the timing. That was what we concluded from our “Worst Market Timer” analysis, which showed that an investor who had invested $100 in US SMID-cap stocks at the worst possible time every year since 1961 would have still vastly outperformed an investor who had bought $100 of large-cap stocks at the best possible time every year (Display 1). How can that be? It’s because small-company earnings have massively outpaced those of large-caps historically. When compounded over long investment horizons, this growth advantage more than offset any short-term erosion in valuations suffered from buying the stocks at their highest price every year.

And this earnings superiority looks sustainable. Wall Street forecasters expect SMID-cap earnings growth to accelerate from 9.8% this year to 16.3% in 2014, or more than four percentage points higher than what analysts are forecasting for large-cap companies. Implicit in those forecasts is the expectation that, as the overall economy strengthens, small companies’ earnings will pick up at a faster clip than they will for large companies.

What’s more, expectations are improving. SMID-cap EPS estimate revisions—a closely watched indicator for growth investors—were positive for the quarters ended June and September, reversing a two-year downtrend. And current forecasts for 2014 EPS are almost a full percentage point higher than at the beginning of the year.

The recent uptick in interest rates bears watching, as the longer-duration nature of smaller-cap growth companies makes their valuations more sensitive to discount-rate changes. But rising rates are also a function of healthier economic activity—a positive for smaller companies, whose earnings are significantly more homegrown and oftentimes more cyclically sensitive than they are for larger firms. And, in contrast to large-caps, smaller-company operating margins are still well below their precrisis peak (Display 2), suggesting that there’s room for expansion as revenue growth normalizes.

Multiple expansion has fueled most of the SMID-cap run since the 2008 market slump as the economy and investor confidence have recovered. But we expect fundamentals to lead the next leg up, giving research-driven active strategies an edge. We continue to find growth companies with the fundamental drivers of outperformance that we target—notably, positive earnings revisions and upside earnings surprises—trading below their long-term average forward-earnings multiples.

All told, we think that it’s far from clear that the bull market for SMID-cap stocks has fully run its course.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Bruce K. Aronow is Team Leader and Portfolio Manager/Analyst for US Small/SMID Cap Growth Equities at AllianceBernstein.

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