Mega-caps get the headlines, but investors can benefit from thinking small

There’s a lot to like about major tech stocks—but over the past decade, small- and mid-caps have grown earnings, on average, faster than their large-cap peers.

While Mega-Cap Stocks Shine, Investors Should Think Small Readers have likely seen the statistics and financial media headlines. Mega-cap stocks—namely major technology companies—have been driving a disproportionate share of total U.S. stock market returns. From the beginning of 2023 to the end of May 2024, a small handful of the biggest technology companies have driven approximately 60% of the S&P 500’s 40+% gain.1 This week’s column is not a declaration that this outperformance is over. In fact, earnings suggest the opposite. The largest tech players have been growing earnings at a staggering clip, and strong positive equity returns have accompanied and often led this growth. The outlook for Q2 and beyond looks like more strength. Total earnings for the Technology sector are expected to be up +15.5% on +9.5% higher revenues for the second quarter, with a 119-basis point expansion in net margins (see chart below). These are very strong numbers. Year-over-Year Change in Tech Sector Net Margins Source: Zacks Investment Research 2 The U.S. is Headed for A Contentious Election Cycle…How Could This Impact the Market? With last week’s debate still making headlines, many investors are wondering how this election could impact the market. From an investment standpoint, it’s important to “set aside political views” and concentrate on fundamentals and data. To assist with this, we have created our special Stock Market Outlook Special Report 3, focusing on election year insights. This report includes expert analysis, detailed forecasts, and more: Expert market strategy commentary A Historical look at the impact of election years Key U.S. economic data And more… If you have $500,000 or more to invest, request our free Stock Market Outlook Special Report 3 today! While price appreciation for mega-cap tech stocks has a fundamental driver in earnings growth, it has also resulted in significant multiple expansion for the sector. For some investors, this strong performance could mean your portfolio has greater exposure to large-cap stocks than it did a year ago (assuming you have not rebalanced). And that’s where “thinking small” comes in. From a pure valuation standpoint, high-quality small-cap stocks trade at a historically large discount to their large-cap peers, even though many of them have similar profit margins and free cash flows. Indeed, over the past decade, small- and mid-cap companies have grown earnings—on average—faster than their large-cap peers. For small caps, stock price appreciation over that time has lagged their large-cap peers, but has also been driven far more by earnings growth than multiple expansion. That’s important. I want to be fair here, however. There are almost always a sizable number of small-cap companies with high growth rates, but also high debt levels and negative earnings. On average, small caps spend about a third of their EBITDA servicing debt, which is much higher than what large caps spend. And in a higher interest rate environment, elevated debt loads could raise the risk profile of this category of small and mid-caps. But for the active investor with a focus on earnings growth, strong balance sheets and free cash flows, and balanced risk-adjusted performance and diversification, small- and mid-cap stocks could offer a unique opportunity in the current environment. Bottom Line for Investors With all the hoopla surrounding mega-cap tech stocks and enthusiasm about Artificial Intelligence, there’s been a narrative that technology stocks are the only sector where investors can generate returns. But history reminds us that high-quality small- and mid-cap stocks have delivered competitive returns to the broad stock market over long stretches of time, in many cases outperforming. With an allocation to small- and mid-cap stocks, investors can not only gain access to companies with strong prospects for long-term earnings growth, you can also reap the potential benefits of broader portfolio diversification—helping to drive strong, long-term risk-adjusted returns. We also cannot ignore all the questions and concerns surrounding the upcoming election, especially after last week’s debate. Many investors are wondering how this election could impact the market. From an investment standpoint, it’s important to “set aside political views” and concentrate on fundamentals and data. To assist with this, we have created our special Stock Market Outlook Special Report 4, focusing on election year insights. This report includes expert analysis, detailed forecasts, and more: Expert market strategy commentary A Historical look at the impact of election years Key U.S. economic data And more… If you have $500,000 or more to invest, request our free Stock Market Outlook Special Report 4 today! About Zacks Investment Management Zacks Investment Management was born out of one of the country’s largest providers of independent research, Zacks Investment Research. Our independent research capabilities from our parent company truly distinguish us from other wealth management firms - our strategies are derived from research and innovation, including the proprietary Zacks Rank stock selection model, earnings surprise and estimate revision factors. 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