Small-mid cap stocks expected to outperform in the near term – Here’s why

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With valuations of smaller tech firms still looking attractive overall, the potential for this segment to benefit from takeovers by larger peers is there.

The Russell 2000 index, comprising 2000 small-capitalization companies, is up by nearly 16.64 per cent year-to-date while the tech-heavy Nasdaq 100 has gained about 10.75 per cent over the same period. Even over the 12-month period, the small-cap index has generated nearly 65.75 per cent return in comparison to about 42.70 per cent return in Nasdaq 100.

Some of the small-cap companies have delivered huge returns to the shareholders and are looking promising even in the long run. But, is the rally in small-cap stocks over or do they have more steam left?

The latest news from US President Joe Biden about the deal with the bipartisan group of senators regarding the infrastructure spending plan could well benefit the small and mid-cap companies across the sectors in the economy.

UBS Chief Investment Office, a firm providing institutional quality advice to private wealth clients, takes a view on the possible outcome of such firms in the near future.

In their view, “Small and mid-sized tech firms have outperformed mega-tech companies in recent weeks, driven by solid results and favorable valuations. The equities of global small and mid-sized tech firms we track have gained close to 10% in the past month versus just under 5% for global mega-caps. This has led some investors to question whether the smaller players are over-extended and whether the time is right to move back into mega-tech stocks.”

UBS Chief Investment Office continues to expect the smaller to mid-sized firms to outperform in the near term. Here’s why:

Smaller and mid-sized tech firms (SMIDs) look set for faster earnings growth, which has yet to be fully reflected in valuations. We expect earnings growth of around 25% this year for the smaller tech firms, versus around 20% for mega-tech.

Recent results have highlighted the solid end-demand trends for SMIDs in key areas like software, digital advertising, and the overall tech supply chain.

Yet the 12-month forward price earnings ratios for the small- to mid-cap segment are typically in the low-to-mid 20s versus the mid-to-high 20s for mega caps. And mega-tech valuations are flat to down only 5% from their peak levels in February versus 10-15% for SMIDs.

Mega-cap stocks are likely to face greater pressure from regulators and tax authorities. In China, the US, and Europe, global mega-techs are coming under more intense scrutiny from the authorities, whether on taxation or anti-trust practices. This may weigh on investor sentiment for mega-techs in the near term.

For instance, Alibaba suffered its first-ever quarterly loss last quarter following a record USD 2.8 billion anti-trust fine. In the US, lawmakers are due to vote on five bills this week that seek to break up the big tech firms after a 16-month investigation on whether they had abused their market-dominant positions.

By contrast, smaller tech players are less likely to be affected by such scrutiny, especially as most governments are looking to level the playing field. The global digital race among nations will also mean governments are likely to be mindful of curbing innovation and creativity among smaller tech players.

With valuations of smaller tech firms still looking attractive overall, UBS sees the potential for this segment to benefit from takeovers by larger peers. By contrast, mergers and acquisitions in the mega-cap part of the market—which are generally less common—look even less likely than usual due to demanding valuations and regulatory pressures.

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