Managing valuation and quality risk with mid caps
Amid a choppy macroeconomic backdrop, allocating to mid-cap equities can help manage valuation risk and quality risk within portfolios.
The macroeconomic backdrop has been variable, making it difficult for investors to position their portfolios for macro trends. In times like these, investors can often get whipsawed as intra-equity leadership within the market rotates. In our view, there are two main risks to focus on managing from an equity perspective: valuation risk and quality/solvency risk. We believe that these risks are important because current elevated valuations will likely weigh on longer-term return potential and higher interest rates will make it difficult for lower-quality or smaller companies to sustain themselves.
Decreasing valuation risk
Mid-cap equities are currently trading at a discount relative to large-cap equities, providing one way for investors to reduce the valuation risk within their portfolios. Historically, the forward price-to-earnings (P/E) ratios for both large- and mid-cap equities have tended to reflect similar multiples, with the ratio of the two P/Es averaging 1.00. However, valuations for mid-cap equities now appear relatively cheap when compared to large caps.
The valuation advantage for mid-cap equities
Forward/P/E of mid caps relative to large caps
Source: FactSet, as of 1/31/23. Mid caps are represented by the S&P MidCap 400 Index and large caps are represented by the S&P 500 Index. The S&P MidCap 400 Index tracks the performance of 400 mid-cap publicly traded companies in the United States. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Last September, the ratio fell to 0.72, meaning that mid caps were trading at a 28% discount to large-cap equities. The only other time in recent history when mid-cap equities have traded at such a deep discount to large caps was just before the tech bubble burst; that low-water mark occurred in March 1999, and over the next seven years, mid caps went on to outperform large caps by 124%.
Recent market performance has slightly narrowed this valuation gap but still shows mid caps trading at a 21% discount to large-cap equities. And though past performance is no guarantee of future returns, we do see some similarities between the recent market environment and the tech bubble. Over the past few years, certain areas of the market such as SPACs, meme stocks, and NFTs have seen valuations that weren’t supported by the underlying fundamentals. As the market shifts back to rewarding high-quality, profitable companies, we believe that this historic valuation advantage could provide support for mid-cap equities in the months ahead.
Keeping quality in mind
On an absolute basis, small-cap equity valuations also look attractively valued but overall aren’t much cheaper than mid-cap equities. In addition, small-cap indexes like the Russell 2000 Index can have significant solvency risk. Roughly 40.0% of companies included within the Russell 2000 Index were unprofitable last year. These small-cap companies also tend to have lower return on equity (ROE), another measure of quality. The average ROE is 6.5% for the Russell 2000 Index compared to 17.4% for the Russell Midcap Index, according to data from FactSet.
With the potential for a recession looming on the horizon and businesses facing a higher cost of capital, we prefer mid caps to small caps due to their higher quality, mitigating the exposure to businesses with low or no profitability.
Sector tailwinds to provide a boost
Looking ahead, we see longer-term positive catalysts that could provide support for mid-cap equities as well. Disruptions in the global supply chain brought on by the COVID-19 pandemic have incentivized many large U.S. companies to begin reshoring jobs, many of which have landed throughout the Midwest. This influx of jobs and capital should help provide a boost both to local economies and the industrials sector overall.
Industrials remains one of the largest sectors within the mid-cap space, making up nearly 20% of the asset class. Mid-cap industrials comprise a diverse group of industries, ranging from industrial machinery to engineering to electronics. These industries are likely to be the areas that benefit most from this reshoring megatrend that could persist for years, creating a secular tailwind for the industrials sector, and in turn, mid-cap equities.
Positioning for the market ahead
While the economic environment is likely to remain challenging for equities, we think investors can prepare by positioning their portfolios for continued market volatility. Having a tactical tilt toward mid-cap equities can provide a complement to large-cap exposure, decreasing valuation risk while maintaining exposure to high-quality names that should hold up if the market tips into a recession.
Important disclosures
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person.
All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients and prospects should seek professional advice for their particular situation. Neither Manulife Investment Management, nor any of its affiliates or representatives (collectively “Manulife Investment Management”) is providing tax, investment or legal advice.
This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Manulife Investment Management shall not assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment approach, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
This material has not been reviewed by, and is not registered with, any securities or other regulatory authority, and may, where appropriate, be distributed by Manulife Investment Management and its subsidiaries and affiliates, which includes the John Hancock Investment Management brand.
Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.
MF2750200