The Case for Small and Mid-Cap Stocks: A Hidden Opportunity for Investors

The Case for Small and Mid-Cap Stocks: A Hidden Opportunity for Investors

Smaller stocks offer relative bargains and historical outperformance, making them an attractive investment option.

In the world of investing, large-cap stocks have long been the darlings of the market. With their household names and inclusion in popular index funds, it’s no wonder that many investors have allocated a significant portion of their portfolio to these giants. However, recent trends and expert opinions suggest that it may be time for investors to consider diversifying into smaller stocks.

The allure of small and mid-cap stocks

Large-company U.S. stocks, represented by the S&P 500, have outperformed their smaller counterparts in recent years. However, this performance gap presents an opportunity for investors. Smaller stocks, with their lower market capitalization, can be purchased at a relative bargain due to the focus on larger stocks. Additionally, historical data indicates that smaller names have tended to outperform larger stocks over long periods. These factors make small and mid-cap stocks attractive options for investors looking to diversify their portfolios.

The case for valuation

Valuation is a crucial aspect of investing, and small and mid-cap stocks currently offer an appealing proposition. By comparing the price-to-earnings ratio (P/E ratio) of stocks, analysts can determine whether a company is over- or undervalued. Currently, stocks in the S&P small and mid-cap indexes trade at around 14 times estimated earnings for 2024, while the P/E ratio for the S&P 500 stands at approximately 20. This means that small and mid-cap stocks are trading at a roughly 30% discount compared to their larger counterparts.

Furthermore, when comparing these ratios to historical averages, small and mid-cap stocks appear even more enticing. Midsize stocks are trading at a 14% discount relative to their average P/E dating back to 2005, while small-company stocks are trading at a 19% discount. This relative attractiveness suggests that either large-cap stocks are overpriced or smaller stocks are underpriced. By investing in smaller stocks now, investors position themselves to benefit if valuations revert to their historical means.

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Long-term diversification benefits

Diversification is a fundamental principle of investing, and it extends beyond simply spreading investments across different sectors or asset classes. Including small and mid-cap stocks in a portfolio provides diversification in terms of market capitalization. By diversifying across different market segments, investors can reduce their exposure to the risks associated with any single segment.

Moreover, historical performance data supports the case for long-term diversification into smaller stocks. Over extended periods, smaller stocks have often outperformed their larger counterparts. While large-cap stocks offer stability and familiarity, smaller stocks have the potential for greater growth and higher returns. By including small and mid-cap stocks in their portfolios, investors can tap into this historical outperformance and potentially enhance their overall returns.

Conclusion:

In a market dominated by large-cap stocks, smaller stocks present an untapped opportunity for investors. With their relative bargains and historical outperformance, small and mid-cap stocks offer a compelling case for diversification. By branching out from the familiar giants and considering smaller stocks, investors can potentially enhance their returns and reduce their exposure to market risks. As Greg Marcus, managing director at UBS Private Wealth Management, suggests, now is a fantastic time to diversify into small and mid-caps. As the investment landscape evolves, seizing this opportunity could prove to be a wise move for investors seeking long-term growth and resilience in their portfolios.