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Road to recovery? Mid-caps attracting attention
31 Aug 2020
A way of constructing a portfolio is by categorizing shares by their market capitalization or market cap which refers to the total value of a company's shares. It is calculated by multiplying the price of a share by its total number of outstanding shares in the market. For example Apple has 4.28 billion shares outstanding and with the price currently around $500 makes it the largest company in the world with a market cap of $2,140 billion. 

Market cap is split into three categories; large-cap, mid-cap or small cap. Large-cap shares which have a market cap of more than €10 billion, tend to be of a lower risk relative to the equity market as a whole as they have a lot of shareholders and are extensively followed amongst different investors and media. On the other hand, small cap shares can have a value normally less than €2 billion and can offer better potential returns with greater risk and are likely to be less diversified since many will be niche business and some even offer few or single products.

Amongst these two extremes there are also mid-cap companies which are normally over-looked. These normally have values from around €2 billion to €10 billion in market cap. 

Before the pandemic struck, sentiment towards smaller sized companies relative to large ones has been very poor. This trend even accelerated during the first-quarter sell-off this year as many of those business models thrived under stay-at-home orders. In Europe, large-caps registered a return of -22.5% for Q1 whilst small-caps and mid-caps registered a return of -28.8% and -25.1% respectively. More recently however, investors are turning their attention towards medium and smaller sized companies that may offer a greater potential in a recovery. Since markets started to recover from their lowest point on the 23rd of March up to 20th August 2020, a stronger recovery was seen in small and mid-cap companies with a performance of +45% and +42% whilst the large-caps are trailing behind at +31%. 

The unprecedented monetary and fiscal stimulus unleashed all over the globe to help the virus struck economies is currently giving steam for holding smaller-mid cap stocks. In many cases this is directly targeted at ensuring the viability of these businesses. These policies have led macro-economic indicators, like the Purchase Managers Index, which are positively correlated to the performance of smaller companies, to constantly improve. In fact this has exceeded the 50 mark which represents an expansion. 

Another tailwind for smaller, domestically oriented companies is the rise of de-globalization. Globalization was already in reverse way before COVID-19 with the backlash from Brexit, the rise of Trump and lately the United States – China trade war. Countries where already looking to increase self-sufficiency and the pressure to shift supply chains closer to home continues to intensify on the back of supply disruptions arising from the coronavirus pandemic. 

Looking at valuation levels over a 20 year period, U.S. large caps appear overvalued in contrast to U.S. small caps with the latter having a higher probability to experience an expansion.

Smaller companies are negatively correlated with high-yield spreads, which is the difference in credit risk with a risk-free bond. This is so as the risk profile of small company is in-line with a typical high-yield bond issuer. Over the years we have seen that as high yield spreads spike, like what happened during the Global Financial Crises, smaller companies generally underperform. Currently spreads seem to be on the downside and hence might give rise to an opportunity.

Mid-caps are not popular as small or large-caps however this trend might change. Although an economic recovery is expected next year, based on fact that the root cause is a health concern, and not a financial one, this recession might take longer than anticipated. Mid-cap stocks might therefore provide the better risk/return trade-off as they are uniquely positioned between small, developing companies and large, mature companies. Mid-caps are in a position to benefit from enhanced access to the capital markets, potentially giving them a financial advantage over small caps in such times. Compared to large-caps, mid-caps are often in the growth phase of their life cycle where they may be experiencing higher cash flows, earnings growth rates whilst having less complex business models.

The analyst’s coverage of the small-medium cap market universe is much less resulting in prices not fully reflecting company data. This might lead to mispricing and thus makes it an ideal hunting ground for active management. Furthermore, company-specific factors have historically accounted for a far higher share of volatility for smaller-to-medium cap stocks than for large-cap stocks. When dispersion of stock returns is high, active managers have greater opportunities to add value through stock selection. 

This article was published on the Sunday Times of Malta on 30 August 2020. It was written by Christian Buhagiar who is a Portofolio Manager at BOV Asset Management Limited (“the Company”).  

The writer and the Company have obtained the information contained in this document from sources they believe to be reliable but they have not independently verified the information contained herein and therefore its accuracy cannot be guaranteed. The writer and the Company make no guarantees, representations or warranties and accept no responsibility or liability as to the accuracy or completeness of the information contained in this document. They have no obligation to update, modify or amend this article or to otherwise notify a reader thereof in the event that any matter stated therein, or any opinion, projection, forecast or estimate set for the herein changes or subsequently becomes inaccurate. BOV Asset Management Limited is licensed to conduct investment services in Malta by the Malta Financial Services Authority.  Issued by BOV Asset Management Limited, registered address 58, Triq San Żakkarija, Il-Belt Valletta, VLT 1130, Malta. Tel: 2122 7311, Fax: 2275 5661, E-mail: [email protected], Website: www.bovassetmanagement.com. Source: BOV Asset Management Limited.
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Bank of Valletta p.l.c. is a public limited company regulated by the MFSA and is licensed to carry out the business of banking and investment services in terms of the Banking Act (Cap. 371 of the Laws of Malta) and the Investment Services Act (Cap.370. of the Laws of Malta).