Finding Small-Cap Stock Opportunities In a Big-Cap World

Blockbuster large-company stocks are taking up the headlines and delivering the best returns. But during the Morningstar Investment Conference, three managers of stock funds that focus on (or include) small-company stocks made the case for why small caps still matter at a panel named “Why Bother with Small Caps In the World of the Magnificent Seven?”

The trio pointed to opportunities in sectors like industrials and consumer discretionary, and across the globe in Japan and the United Kingdom.

While the shine has come off of two members of the Magnificent Seven—Apple AAPL and Tesla TSLA—large caps continue to outperform, with the Morningstar US Large Cap Index beating the Morningstar US Small Cap Index by more than 18 points in the year to date. Even going as far out as 15-year trailing returns, the large-cap index beat the small-cap one by just over 3 percentage points per year.

Finding Value In the Shadows of Giants

Despite this dreary backdrop for small caps, the panelists had plenty of ideas for finding attractive buys in the space.

Morgen Peck, a portfolio manager at Fidelity Investments, said she’s concentrating on “companies that can compete and find some small niche … We’re having luck with companies in markets too small for big companies to care about.” She talked about how international markets had attractive valuations compared to the US, looking at the UK across different sectors and industrial and consumer firms in Japan. In the US, she is more interested in cyclicals like industrial, materials, and consumer discretionary stocks.

Don San Jose, chief investment officer of the US value Team at JP Morgan Asset Management, echoed the attractiveness of industrials and other cyclicals.

Keith Lee, chief executive officer and senior portfolio manager at Brown Capital Management, has a different take. “We define size in terms of operating revenue,” he explained, with Brown favoring companies with less than $500 million in annual operating revenue for domestic stock funds. He focuses more on growth-oriented companies than the other two managers, and he keeps an eye on healthcare and technology firms.

AI Stocks and Small-Cap Investing

As artificial intelligence and machine learning have been major trends sending mega-cap stocks soaring, all three managers said they were primarily concerned with how firms might utilize AI to improve their businesses, rather than those that directly benefit from AI demand. Peck says her teammates “are not thematic investors trying to find the new AI thing,” and that the market was too often grouped into “AI winners and AI losers.”

The three managers also mentioned that they’ve not let the meme stock craze—which focused on many small-cap companies—change their investing. Lee says the key to fund management is “consistency in how you invest. Sometimes you look like a genius and sometimes you look like an idiot. Sticking to your discipline is what matters. That’s what wins.”

Private Markets and Rates

The managers acknowledged some challenges facing small-cap strategies, like the trend of companies staying private longer, which has reduced the number of publicly traded small caps. However, Peck notes that looking at markets globally, there are still many thousands of small-company stocks.

Another issue has been higher interest rates, which can disproportionally hurt small-cap firms. San Jose said, “Rates will likely head lower, but if anyone can tell you for sure when that’s gonna happen, I’m going to be the first to buy their product.” Lee added that he is more focused on longer-term performance. However, he’d be happy with a different macro environment: “We like the wind at our backs, not in our faces.”