The Magnificent 7's (Mag 7) market dominance and chart-topping performance have captured headlines in recent years. Small caps, by contrast, have lagged in performance and market attention. Nonetheless, there is a strong case to be made for investing in quality small caps today.
Anyone with even a passing interest in the equity market over the last few years is likely familiar with the Mag 7—those select, and undoubtdedly impressive, household names that have driven a significant portion of the S&P 500's performance—and now represent a large percentage of that benchmark.
The Mag 7 are emblematic of a broader trend of rising market concentration, a dynamic seen several times throughout market history, as others, such as Mauboussin and Callahan of Morgan Stanley Investment Management, have observed.1
A decade of large-cap concentration
2014 marked the beginning of this most recent period of rising market concentration that has seen a handful of large-cap winners dominating equity returns. Over this decade-plus run, this upper echelon of market darlings has also accounted for a meaningful portion of total economic value creation, while generating enviable free cash flow, growth and returns on invested capital.2 In other words, they've earned it!
When coupled with the prolonged underperformance of small-cap stocks over this same timeframe, perhaps justified by their inferior return on invested capital (ROIC) characteristics compared to their large-cap peers, many have concluded that the small-cap universe has little to offer. Herein lies the myth.
Quality small caps outperform
The small-cap universe, as measured by the Russell 2000®, offers significant opportunities for capital appreciation when approached with a quality lens, even in a period characterized by large-cap dominance and increased market concentration. We believe a high-quality, actively managed small-cap allocation can still offer attractive risk-adjusted returns in a well-diversified portfolio that includes large-cap holdings.
Since 2014, despite the dominance of the Mag 7, there are literally hundreds of small-cap stocks one could have purchased at the start of each year and, if held, would have outperformed the cumulative return of the S&P 500 (through 6/30/24).
In our view, one of the best measures for identifying quality in this small-cap opportunity set is ROIC. Looking back over the 20 years preceding this current period of market concentration, a high-quality, small-cap allocation, as measured by ROIC, has produced returns that are competitive with, and frequently surpass, large-cap equities.
Bottom line: We do not know if we're nearing the end of rising large-cap market concentration. But we do know that an active, quality-focused approach to small-cap investing is worth considering for a portfolio allocation, regardless of whether the Mag 7's days of dominance are numbered, or not.
1. Morgan Stanley, Consilient Observer, June 4, 2024, "Stock Market Concentration: How Much is Too Much?" by Michael J. Mauboussin and Dan Callahan, CFA.
2. Ibid.
S&P 500 is a stock market-capitalization weighted index tracking the stock performance of 500 of the largest U.S. companies.
Russell 2000® Indexis an unmanaged index of 2,000 U.S. small-cap stocks. Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index. Historical performance of the index illustrates market trends and does not represent the past or future performance of any investment.
Risk Considerations: The value of investments may increase or decrease in response to economic and financial events (whether real, expected or perceived) in the U.S. and global markets. The value of equity securities is sensitive to stock market volatility. Smaller companies are generally subject to greater price fluctuations, limited liquidity, higher transaction costs and higher investment risk than larger, more established companies.
