The case for small and mid caps

Episode Summary

Executive Summary: The episode examines whether the recurring “time to buy small caps” trade is finally justified. Aiden Writer and Katie Martin argue that while small and mid-caps have lagged mega-cap U.S. stocks, the case is stronger for mid-caps than small caps because they are cheaper, more profitable, and better positioned for rate cuts. But they also caution that large-cap dominance, weak small-cap fundamentals, and oligopolistic market power may keep the gap wide for now.

Main Topics: The recurring small-cap comeback narrative (Priority: 5/5): The hosts frame small caps as a perennial market theme that often resurfaces after periods of underperformance, questioning whether current optimism is another false dawn or a genuine opportunity. Performance gap versus large caps (Priority: 5/5): They compare S&P 500, S&P 400, and S&P 600 returns and note that despite positive gains, small caps have badly trailed large caps over the past five years, especially versus the Magnificent Seven-driven rally. Valuation versus fundamentals (Priority: 5/5): Small and mid-caps trade at a meaningful discount to large caps, but the discussion emphasizes that cheap valuations alone do not guarantee a rebound because profitability and margins remain weaker. Profitability and margin quality (Priority: 5/5): Aiden argues that lower profitability among small caps helps explain underperformance, with a significant share of small-cap companies unprofitable and margins lagging large-cap peers. Interest rates, debt, and the limits of the bullish case (Priority: 4/5): The common Wall Street argument that small caps benefit disproportionately from falling rates due to floating-rate debt is challenged; the speakers say debt burdens are probably not the main driver of their weak performance. Private equity and market structure (Priority: 4/5): They discuss whether private equity has removed the best small companies from public markets and whether large-cap firms’ market power is squeezing smaller suppliers, though they say the evidence is hard to prove. UK stocks and mid-cap preference (Priority: 4/5): Katie links the small-cap debate to UK equities and says the same ‘cheap and overlooked’ argument exists there, but she personally favors mid-caps as the more attractive contrarian trade.

Key Arguments: Small caps are theoretically riskier and should earn higher long-run returns, but that theory has not reliably played out in recent years. Over five years, large caps have outperformed mid-caps and small caps substantially, with the S&P 500 far ahead. Small and mid-caps are cheaper than large caps by roughly a third, but valuation is not a timing mechanism. Profitability is weaker in smaller indices: only 77% of S&P 400 companies are profitable, versus 91% of large caps and almost all big caps. The “small caps have more floating-rate debt” story is probably overstated; debt does not seem to explain most of the underperformance. Private equity likely does take good small companies private, but the transcript says the supporting data are too fragmented to prove the effect cleanly. Mid-caps look more attractive than small caps because they combine cheaper valuations with better profitability and a more manageable risk profile. Large-cap firms may be increasingly able to squeeze suppliers and service providers, which harms smaller companies and helps sustain the gap. Rate cuts could help mid-caps, especially sectors like regional banks and insurers, but not enough to make small caps an obvious near-term winner. For the next quarter, the hosts are skeptical on a broad small-cap rally, though one speaker is gradually shifting toward medium-sized stocks in his own portfolio.

Data Points: S&P 500 five-year performance: up about 90-something percent - Rob cites S&P Capital IQ to show large-cap outperformance over five years S&P 400 five-year performance: up 60-something percent - Mid-caps have lagged the S&P 500 but outperformed small caps S&P 600 five-year performance: up 50% - Small caps have posted gains, but well below large caps Mid-cap profitability: 77% profitable - Share of companies profitable in the S&P 400 Large-cap profitability: 91% profitable - Rob contrasts this with mid-caps to show stronger large-cap fundamentals Valuation discount: about one-third cheaper - Small caps and mid-caps are said to trade at a large discount to large caps Relative valuation of small vs. mid caps: about the same price - Despite different business profiles, small and mid-caps trade at similar valuations Peak summer outperformance: biggest outperformance in about 40 years - Aiden describes a brief summer surge in smaller-cap stocks versus the S&P 500 Fed rate cut: 0.5 percentage point - Mentioned as part of the backdrop for the recent small-cap rally

Pivotal Quotes: "The theory is not panned out, which means a lot of people who invest according to the theory have had a very frustrating couple of years." — Katie Martin: On why the traditional risk-premium argument for small caps has disappointed investors "There’s a lot of loss leaders among the small caps." — Aiden Writer: On weaker profitability in the small-cap universe "I think mid-caps look better, but I’m going to say no." — Aiden Writer: His view on whether small and mid-caps are the big Q4 trade

Implications: Listeners should be cautious about chasing a broad small-cap rebound. The stronger case is for selective mid-cap exposure, but only if rate cuts and economic stabilization improve fundamentals; otherwise, large-cap dominance may persist.