The Changed Landscape in Small- And Mid-Cap (SMID) Stock Investing 

U.S. small-cap stocks were the darlings of capitalism in the decades following World War II. 

They generated one to two percentage points of excess return a year over large caps for more than 50 years. These equities benefited from a dynamic public capital market that provided substantial growth capital. Small-cap companies often went public and were able to grow themselves into large caps if the business model was successful. 

These days small-cap investing just isn’t the same. The investible universe in small caps (companies with $200 million to $2 billion in market capitalization) has shrunk as private capital markets have developed to compete with public ones. A substantial portion of this shift—a reduction in public companies and reliance on private capital—is largely a result of burdensome regulations that emerged after the 1990s tech bubble burst. 

Since then, many small caps have been taken private or acquired, and fewer companies are being brought to market because smaller companies can find ample capital for growth from private equity and credit investors. Two decades ago, there were roughly 8,000 companies in public markets. That number has been cut in half. 

The opportunity for SMID company outperformance remains, but finding it requires understanding the market shifts of the past twenty-five years. Small- and mid-cap stock indexes have changed. Indeed, mid-cap indexes did not exist as an asset class twenty-five years ago. Much of what were categorized as small caps back then have been recategorized as mid-caps ($4-$18 billion in market capitalization). This has left pure small-cap indexes with a high proportion of unprofitable companies. Investors need to recalibrate their perspective to focus on profitable companies in small- and mid-caps (i.e., SMID-caps). A combination of profitable and growing SMID-caps could generate outsized returns similar to the post-WWII era over the long run. 

Bottom Line – The potential opportunity to generate strong returns that reflect the post-WWII era of small- and mid-cap stock dominance remains in companies that generate strong profits.