This article has been written by expert contributor Fidelity International
Segmenting the market
The value of companies listed on stock exchanges around the world varies enormously. Apple became the first firm ever to reach a valuation of US$3 trillion in early 2022;1 the smallest firms, on the other hand, are typically worth in the millions of dollars. A useful way to begin this journey is to segment companies in terms of their market capitalisation – or market cap. In this way, each listed company can be broadly categorised as either large-cap, mid-cap or small-cap, depending on its value. It is the large-cap stocks that investors are usually most familiar with, and which dominate well-known market indices.
Looking beyond the large caps
Although large-caps dominate the headlines, it would be a mistake for investors to ignore the multitude of mid-caps and small-caps on offer, as these could well offer better growth and returns. After all, on their way to becoming large- caps, the likes of Apple, Microsoft and Amazon began life as small-caps or mid-caps. As they grew to become superstars, their valuations multiplied several-fold, and those who invested early reaped the rewards of holding these so-called ‘multi-baggers’ – that is, companies whose valuations increase by many multiples. The difficulty, of course, lies in identifying these future industry leaders at their early stages of growth – while keeping in mind that for every Apple that makes it, countless others don’t. This is made more challenging by the fact that investment analysts focus most of their research efforts on large-caps, which comprise the bulk of major indices and investment portfolios. Yet therein lies the opportunity, since the relative lack of research on mid-caps and small-caps increases the likelihood that high-quality businesses with tremendous growth potential are flying under the radar and trading at attractive valuations.
Characteristics of small, mid and large cap segments
What’s also important for investors to understand is that small and mid-cap segments of the market may have differing characteristics relative to large-cap segments, as the table illustrates.
Over the past 25 years or so, taken as a market segment, global mid-caps and small-caps have generated higher returns than large-caps (see Figure 1). Looking ahead, new leaders will continue to emerge from the mid-cap segment – in part due to the difficulties incumbents face in staying ahead of the curve. After all, large established firms may not have the appetite to develop new, disruptive technologies or ways of operating.
There is no shortage of examples of this in action. Take electric vehicles: While it may be more challenging for the world’s most established car manufacturers to do a hard pivot to focus on electric engines, Tesla has had no such concerns. The success of small and mid-cap companies may also make inroads into markets held by incumbents much faster than expected. Twenty years ago, few would have imagined the force Amazon has become in retail. Amazon founder Jeff Bezos famously predicted his company would eventually fail, and that lifespans of large companies ‘tend to be 30-plus years, not a hundred-plus years’.2
Reality is, just a handful of today’s small-caps and midcaps will one day emerge as future leaders within their fields. Defining the ingredients to success is often difficult as it requires understanding the competitive nature of the market, their competitors, the financial position of the company and what is unique in their product or service that differentiates them. Successful companies in the global mid-cap universe are typically structural winners, technology disruptors, innovators, category killers or brand leaders. Some are unique niche operators or specialists that dominate their field. Others are part of a large global theme. Sectors such as technology, healthcare, globally focused consumer, and industrials have more recently been home to such business models.
Many of these businesses are also founder-led. Where they are, their management teams tend to be innovative and agile, and their interests are generally strongly aligned with those of outside shareholders.
Sustainability mindset integral for small and mid-cap companies
At Fidelity, within the context of a fund portfolio and at an individual stock level, we think about ESG factors holistically. Any company with the ambition of becoming a future leader must operate with a sustainability focus to retain its viability and credibility as a long-duration business. Without an ESG conscious and ESG inclusive approach, not only will the cost of capital rise significantly for businesses, but their products and services may also not be able to capture market share in their specific areas. Simultaneously, experienced investors would also vouch for the importance of assessing the stock and company’s sustainability credentials and differentiating it from a momentum-driven uptrend in a ‘green theme’, to ensure that both the returns on capital can endure and as institutional investors, we continue to adhere to our sustainability pledges.
Why go global?
Over the past decade in Australia, we’ve witnessed some amazing mid-cap and small-cap businesses evolve from an idea to established international businesses including now well-known names such as Domino’s, Resmed, and CSL. Looking beyond Australia makes sense; it brings a greater chance of finding those unicorns because the global mid-cap and small-cap opportunity set is far broader and deeper. Investors have the opportunity to capture significant growth, as shown by the returns generated by some global mid-cap firms in Table 3.
Sources:
1. See: https://www.nasdaq.com/articles/apple-becomes-first-company-to-hit-%243-trillion-market-cap .
2. Richard Kestenbaum, ‘Jeff Bezos Says “Amazon is Not Too Big to
Fail.” He’s Right’, Forbes, 16 November 2018: https://www.forbes.com/sites/richardkestenbaum/2018/11/16/amazon-is-not-too-big-to-fail-bezos/?sh=705b55da1626 .
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Prior to making an investment decision, retail investors should seek advice from their financial adviser. This document is intended as general information only.