When Lower Beta Still Outperforms

There’s always a case for owning small and mid-cap U.S. stocks… but right now, it’s hard to ignore just how compelling that case has become.

Small and mid-cap U.S. stocks are currently trading at a pretty big valuation discount relative to large-caps — JP Morgan’s latest Guide to the Markets shows that small-cap forward P/E ratios are well below their 20-year averages (and well below where large caps are sitting today).

The Russell 2500 keeps lagging the S&P 500 (not just in returns, but in attention). 

It’s gone up less in rallies, down more in sell-offs... even though many of the businesses inside it have more domestic exposure and less reliance on global trade than their large-cap peers. 

You’d think that would earn them a bit of a premium in today’s macro environment. Instead, we’re seeing the opposite.

Valuation gaps between small/mid-caps and large caps are approaching levels we’ve only seen a few times in the last 20 years… and that disconnect is creating one of the more compelling entry points we’ve seen in a while.

“As of the end of June 2024, the value spread between small and large caps is at levels not seen in over 20 years (see the red dashed line), offering a multi-decade opportunity for investors. Specifically, small-caps are trading at a discount of over 20% compared to large caps, based on a composite of valuation ratios (P/B, Fwd P/E, P/C, and 1/DY), while they have traded at a premium of up to 30% in the past.” -Robeco

Even with this relative undervaluation, small and mid-caps have been hit harder on the downside and lagged on the upside. During the recent “Liberation Day” sell-off, the Russell 2500 dropped more than the S&P 500... despite being less globally exposed and, at least in theory, better insulated from trade shocks. 

Put another way, it goes up less when the market rallies, and down more when things sell off. We believe that mismatch isn’t sustainable — and that’s exactly where we see opportunity.

But this macro-climate isn’t just about opportunity… it’s about how we’ve approached it (and why the way we structure our SMID strategy is designed to deliver across cycles, not just catch a wave).

Let me show you what I mean.

A lower-beta portfolio with real upside

Over the past few years, our SMID portfolio has done exactly what it’s designed to do — outperform the Russell 2500 net of fees by nearly 3%, while taking on less risk. We’ve had lower beta, lower volatility, and better downside protection (and we’ve still managed to outperform in up markets).

But the real story is how we got there.

Our basket approach (diversification across Mature, Established, and Emerging businesses) isn’t built to chase home runs. It’s built to compound steadily... to protect capital in drawdowns, and to keep us in the game long enough to benefit when the broader market catches on to the same fundamentals we saw months ago.

You’ll see this in the shape of our portfolio: diversified, lower beta, with position sizing and a basket design that creates what I’d call an “all-weather” posture. Not flashy… just effective.

Why now? Because the market’s missing it

We’ve made this case before (in letters, in meetings, in one-on-one conversations, etc.), but the math keeps getting more compelling. Valuation spreads like this don’t show up very often (and when they do, they rarely last). So the question becomes — what’s everyone waiting for?

In our view, this setup is tailor-made for investors who want to compound capital without chasing heat. You’ve got a historically cheap segment of the market, less global exposure, and a chance to participate in a catch-up trade if sentiment shifts (which we’re already doing with lower beta than the index…).

Small and mid-cap stocks are trading at a steep discount relative to large-cap — not just on a forward P/E basis, but across most valuation metrics. Historically, these kinds of gaps don’t last... and when they start to close, they tend to do so quickly.

In other words, there’s room to run — and not just for beta-chasers. That’s the part that often gets missed in this conversation. You don’t need to load up on volatile, speculative names to capture this upside. You just need a disciplined approach that identifies durable businesses trading at attractive valuations (and a structure that can keep you in the seat through the bumps).

Our view: This is the moment the strategy was built for

We’ve talked before about why we favor fundamentals over short-term noise, and why we think a less concentrated, more adaptable approach is better suited to this corner of the market. That philosophy hasn’t changed.

What’s changed is the environment.

There’s a window right now — a rare one — where you can get exposure to mispriced assets without taking on the full brunt of market volatility. And if you’re already thinking about portfolio durability heading into the second half of the year (as we would argue you should be), I think SMID cap deserves a closer look.

Of course we’re biased… we do run a SMID strategy after all. But the data’s there… and the structural advantages are, well, built in.

If you want to see how we construct our SMID baskets, or what we’re seeing under the hood in today’s market, drop us a note. We’d be more than happy to talk through it.

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