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Written by: Meera Pandit
After an impressive equity rally in 2023 and new all-time highs to start 2024, investors are evaluating their equity allocations, which includes where to position along the market cap spectrum. While small caps are at attractive valuations, quality in large caps may be more beneficial in the year ahead, and mid-caps provide a compelling middle ground. To assess the best opportunities by market cap, we evaluate the following criteria:
- Valuations: Currently valuations are stretched for large caps, with the current P/E 127% more expensive than its 20-year average. Mid-caps look fairly valued, trading at 103% of their long-term averages, relative to small caps which are slightly cheap at 99%. This valuation dispersion is less acute for value but more acute for growth. (GTM page 12)
- Sector composition: Given index concentration among a narrow set of stocks, large cap is highly tech-oriented, while mid-caps have the highest exposure relative to large and small caps to industrials, materials, real estate, and utilities. Small caps have the highest relative exposure to financials, consumer discretionary, energy, and health care. If the rally broadens out, mid and small caps could benefit, but if the economy slows those cyclical areas could face headwinds. However, it is not just what sector exposure is, but how compelling the underlying companies are within those sectors, which profitability can help decipher. (GTM page 11)
- Profitability: Although we do not expect a recession, the economy is likely to slow, which could challenge revenues and impact profits, so quality is key. Over 41% of the small cap index is unprofitable, compared to 17.5% in mid cap, and 7.4% in large cap. Profit growth for the S&P 500 is estimated to be 12% in 2024 after tracking slightly down in 2023. Mid-caps are expected to post 8% y/y growth in 2023 and 2024, while small caps are anticipated to rebound from profit declines of 10% in 2023 to 23% growth in 2024. However, estimates have only been revised down slightly for large and mid-caps for 2024, while small caps estimates have already been revised down 9% in the last three months. (GTM page 7)
- Debt service: Interest costs are rising after Fed hikes, but both large and mid-caps have interest coverage ratios, which measure the ability to service their debt, above their 25-year averages, compared to small caps which have dipped below their long-term averages. In addition, higher rates may impact smaller companies sooner than larger companies because nearly half of S&P 500 debt outstanding matures after 2030 compared to 14% of the Russell 2000, and contains just 6% of floating rate debt compared to 38% in the Russell 2000. (GTM page 11)
- Costs: Although wages and input costs have recently slowed or receded, they have reset at higher levels than pre-pandemic. According to the NFIB survey of small businesses, inflation and labor quality continue to be their top concerns. These structurally higher costs tend to be absorbed better by larger companies with more robust balance sheets than smaller companies.
Although a broader rally and favorable valuations could benefit small caps, large caps appear higher in quality based on balance sheets and margins, with more realistic profit growth expectations. Mid-caps provide a reasonable middle ground for investors looking to diversify large cap exposure.
Sector composition
% of index market capitalization
Source: FactSet, FTSE Russell, NBER, J.P. Morgan Asset Management. The S&P 500 is used for large cap. Russell MidCap is used for mid cap. Russell 2000 is used for small cap. All data are as of January 19, 2024.
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