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Oct 3, 2022

Good Things Come In Small Packages: Why We Like Small And Mid-Cap U.S. Stocks

by Ryan Modesto

We all know that good things come in small packages. It might be the element of surprise—almost anything could be contained in a small package. The big stuff like a car, T.V., or maybe a dog is all great but obvious the moment you see it. Maybe it is the fact that if someone is gifting a small item, you know it is going to be something that is big in another way. No one is going to give you a paper clip or toothbrush as an individual gift. Rather, it is either going to be sentimental or of high value! Well, we think small-cap stocks offer a similar type of proposition: full of surprises and can have a great deal of value.

Closer to the end of 2020, Peter Hodson and I, with Belco Private Capital Inc., launched the i2i Long/Short U.S. Equity Fund, a fund focused on small and mid-cap U.S. stocks. Naturally, being Canadian and operating in Canada, it begs the question of why U.S. small and mid-cap (SMID-cap) stocks are in the first place. So, let’s look at some of the reasons why we like U.S. SMID-caps.

More Opportunities

The first reason is obvious; the SMID-cap space in the U.S. is multiple the size of the Canadian SMID-cap space. One of the reasons we like small and mid-cap names, to begin with, is that they tend to fly more under the radar, and markets tend to be slower to catch on to promising companies. As an example, we count roughly 57 analysts who cover Amazon. That is 57 people whose full-time job is to know every detail about Amazon, and that’s only formal analysts, not other market participants. Meanwhile, the typical SMID-cap name tends to have somewhere around five analysts covering them. This is not unique to the U.S. but is a general reason why we like SMID-cap in and of itself.

The set of opportunities available in the U.S. for SMID-caps is far larger compared to Canada. A simple way to gauge this is if we look at the U.S. SMID-cap index, Russell 2000, compared to the Venture composite and/or TSX composite. The TSX Venture Exchange has about 160 constituents within it. Only three constituents have a market-cap of over $1 billion, and the list reaches sub-$300 million quickly, with 52 names below $100 million in market-cap. 

The TSX 300 composite actually consists of 238 companies, according to Refinitiv Eikon, and we consider a SMID-cap name in Canada as sub $20 billion in market-cap. This gets us to roughly 194 companies within this index. 

So, using a generous scenario, the SMID-cap investable universe in Canada (excluding CSE and so on) is about 354 companies. The Russell 2000 has about 1,975 constituents with market-caps ranging from $10 billion to $130 million. This puts the U.S. SMID-cap space at roughly 5.5 times the size of Canadian markets.

More Growth

With a larger opportunity set in the U.S., it also makes sense to expect the list of high-growth companies in the U.S. to be larger. The economy and population in the U.S. are larger, so companies operating in this area might be exposed to more growth naturally. Casting a wide net using a screen from Refinitiv Eikon, we see 1,238 companies trading in the U.S. with an expected revenue growth rate of 15% or greater. For Canada, this list consists of 271 companies. So, there are about 4.5 times more companies that fall into the growth category in the U.S. vs Canada.

U.S. SMID-Caps Are Cheap

We think the graph below is worth a thousand words, as it shows us the price-to-earnings ratio for mid-caps (top) and small-caps (bottom) for the last 20 years. We are using the S&P 600 and 400 as it tends to be a higher quality SMID-cap index with less noise compared to something like the Russell 2000. If you extend it out to 30 years, you get essentially the same result, which is that outside of 2008, SMID-caps have almost never been this cheap. What is particularly surprising is that mid-caps are even cheaper than the valuation trough in the heart of COVID-19. To put this another way, mid-cap stocks are cheaper now than when we were facing a global pandemic and literal global economic shutdown! Things might not be great in the world right now, but we don’t think it is controversial to say that they are not as bad as in the middle of the emergence of COVID-19.

While mid-caps are not at trough levels of the 2008 great financial crisis (GFC), the valuations are again at least flirting with those levels. Again, while things might not be great currently, we think most would be stretching to try to draw parallels to the GFC.

SMID-caps trading at levels that investors have not seen for nearly 30 years or more is another reason we like the SMID-cap space.

U.S. SMID-Caps Are Cheap Relative To The Alternative

While the chart below is self-explanatory, the one on the next page might require some preamble. Here, we are comparing large-caps (S&P 500) to mid-cap stocks based on the dividend yield (upper chart) and the P/E ratio (lower chart). For dividend yield, the higher the yield, the cheaper you might expect stocks to be. The downward sloping chart shows that relative to large-caps, mid-caps are at lows from a valuation perspective. While the bottom chart is moving in a different direction, it tells us a similar thing. A lower P/E ratio for mid-caps relative to large-caps means an upward sloping line because, again, mid-caps have seldom been this cheap relative to large-caps.

We think this is a nice feather in the cap for mid-cap stocks. Not only are they cheap on an absolute basis historically, but they are also cheap when compared to the other primary option in stocks, large-caps.

US Small vs Large Caps 

 Large Cap vs Mid Cap US Stocks

U.S. Dollar Exposure Can Be A Good Hedge For Canadian Investors

For the sake of brevity, we won’t spend too much time on this point, but the U.S. dollar (USD) tends to be a flight to safety asset. This means that when things look bad, assets flow to the U.S. dollar, increasing relative to other currencies. In turn, for Canadian investors, in a market downturn, the USD tends to rise, making assets worth a bit more in Canadian dollar terms. Over the last five years, there has been a negative correlation between the S&P 500 and the USD/CAD exchange rate of about -0.5. So, when the S&P 500 goes down, the USD tends to go up, offering a bit of a natural hedge.

These are a few reasons why we find the U.S. SMID-cap space so interesting and rich with opportunities while being a space that tends to be overlooked by Canadian investors. One of the reasons we think it gets overlooked is because the opportunity set is so large that it can be a bit overwhelming. Fear not, because just like that gift in a small package, U.S. SMID-Caps could be the gift that keeps on giving!

Ryan Modesto has a financial or other interest in Amazon (AMZN). The i2i Long/Short U.S. Equity Fund does not hold a financial or other interest in any securities mentioned at the time of publishing.

Belco Private Capital Inc. (“Belco”) is the investment fund manager, portfolio manager and exempt market dealer for the i2i Long/Short U.S. Equity Fund. Ryan Modesto is a Portfolio Manager for the i2i Long/Short U.S. Equity Fund and CEO of 5i Research.

Nothing in this article should be construed as investment advice or a solicitation to take investment action. Further inquiries and information can be found via email to Ryan at