Adjusting Small and Mid-Cap Investments for Optimal Asset Allocation

Welcome to Ewa’s finlit podcast. Ewa is a fee only RAA based out of Pittsburgh, Pennsylvania. We hope all listeners of this podcast will benefit as we deep dive into complex financial topics that we will make simplified for you. And we hope that this really serves as a catalyst so that you can make the best financial planning decisions for your family and also save time. Welcome, everyone. Today’s episode joined here by Jameson Smith. We’re going to be talking about the current underweighting in mid and small caps. We’re recording this in August of 2024. We’ve always maintained asset allocation diversification. However, during different economic cycles, how we asset allocate is very important to navigate certain times. So, Jameson, start off by giving just what’s the history of these different asset classes as it relates today’s discussion?

Yeah, so we’ll primarily focus on us large cap and us small caps, just to give a general overview. At a basic level, large caps, obviously, like the large companies in the US, your Amazon’s, Tesla’s, Apple companies, everyone knows they’re huge. They’ve been around for a long time. Small cap would be smaller companies that aren’t obviously as large yet. So looking back at history the last hundred years, there is, they’ve performed pretty similarly. But small cap has won by a little bit. So since 1926 to 2023, small cap has been between about eleven to 12% rate of return. Large cap has been between a ten to 11% rate of return. So they perform differently in different economic cycles, which we can take a deep dive in. Why we’re obviously, like you said, recommending more of a tilt towards large cap.

But one of the big things is just generally, large cap stocks are more stable, more profitable, less volatile, whereas small cap, there’s a lot more volatility and risk. So you could see some more upside, but it’s important to know you’re taking on a lot more risk to get some of that upside.

Absolutely. Well, the. So risk is obviously measured in standard deviation, and the standard deviation essentially volatility. So when small caps are good, they can be really good. When they’re bad, they can be really bad. And it could be catastrophic if you’re overweight and they’re really bad, period. So, well, tell us. So from a, give us some recent examples, like 2010, post 2008, and then 2020 and beyond. What are some of the recent data that we’ve seen?

Yeah, I’d say in general. So any type of bull market, large cap stocks generally, or small cap stocks generally outperform. So the last 15 years in the US from post 2008 2009 financial crisis up until COVID pandemic and then 2024, large caps really crushed it. Or small caps, really. Small cap is outperformed in the bull markets. In any type of volatile market recession, large cap’s going to win generally, reason being smaller companies. So if we look at the climate of the last couple of years, high interest rates, small companies generally rely on lending from banks, raising capital from investors. A lot of time the investors are borrowing money. So it’s much harder to get money when the interest rates are high, as well as any type of recessionary period which haven’t been in a recession.

But if people are spending less money, inflation is higher, less people have jobs, smaller companies could suffer more. Whereas the large companies have a lot of cash on the balance sheet, they’re highly profitable. They’re able to shift and navigate and withstand some of those times. But to your question, looking at time periods, basically post.com bubble 2000 2010, small cap stocks outperformed large. Captain, a lot of that was due to these tech companies were really on the up and these small companies took off. And obviously some of the tech companies made it post 2008 to, like I said, to now large cap has outperformed. And then 2020 and beyond. Basically, there was Covid-19 pandemic in 2020. Both dropped significantly. And then large caps generally will recover faster.

And so there was a big rebound in small cap stocks, 2021, but in general, they’ve been fairly stable. Obviously, we’re favoring large cap right now. But I think one of the things to note is if you were to look at the s and P 500 index, there’s going to be less. Even if a year where the S and P 500 goes up, not all 500 companies are positive. There’s obviously five and close. Yeah. A portion of them are negative. What’s interesting is when you look at a small cap index, there will be, I don’t have data to back this up, but I’m guessing there’s going to be more companies that are at a loss because you have these companies like think of like an Uber, for example.

You may have that one or two or five that like explode, and they’re going to make up for the growth of all of those losers. So there’s just more volatility and more uncertainty in the small cap space.

Yeah. So just to put like a high level reasoning on why we are where we are today. So, like, on average at EWA, if you were like 100% equity portfolio, we would have typically maybe 60% large cap, 12% between mid and small. So over two thirds of the portfolio would be in the US and the other less than one third would be international. Between international developed, international emerging right now, currently we’re 65% in large cap and only 5% in mid and small. So we’re about half, a little bit less than half of the position we’d typically be in mid and small. And the high level reasoning behind that is in large caps, we still see huge earnings per share growth, like 18.9% year over year. And in small caps right now, it’s still, it’s negative year over year.

So there’s a lot of reasons behind that. But I would say if I were to give one or two reasons, it would be what used to be very easy money and what people would call free money out there has totally changed a lot of these small companies. Banks aren’t going to give a small company a loan quickly like they would have a couple years ago. And if they do, that loan’s going to be, you know, maybe at a 7% rate instead of a 3% rate. And so we’re talking in like hundreds of millions of dollars. A 1% difference can be huge. A 3% difference could be a cash flow going from positive to completely negative overnight. So with that being said, we see a lot of small and mid companies. They’re just not able to post profits right now.

They’re in the red, and we continue to see them in the red until some headwinds change.

Yeah. Why don’t you give like a current, if were to look at the current economic situation now, what’s going on? And then kind of we’ll pivot that into why our portfolios are how we have them.

Yeah, so, I mean, the other thing too is when you look at really good small companies, a lot of. So if you look at all companies that are private, small companies that are private in 87% of firms that have a revenue greater than $100 million are private right now. And out of these firms, they actually are 80% of job openings. So if you look at just like the s and P 500, for example, that’s 18% of the total us employment. So private sector looks for a lot of. So if you look at, like, you’re a small company, you’re wanting to grow and grow, and eventually get public, you may miss that mid, that small and mid cap stage of being a publicly traded company and go right to market as a large cap company.

Or we’re seeing that often because it’s just easier to get private money, someone that really believes in your company, it’s typically huge investors, and it’s a lot easier to get money from a couple people than it is to be public and have to post results every quarter. And having all the pressures and a.

Lot of your valuation, it’s just all public image. So it’s all. Whatever shareholders think of you, whatever the public thinks, way harder to do that than be private. And you worry about the business owners, your company itself. It’s just a totally different landscape, can be much more difficult.

Absolutely. It’s quite outstanding. We’re still big believers in small and mid companies, but as far as a lot of the quality companies, they’re private right now. And a lot of the quality companies in the large cap are actually inequality focused investment in the large cap, where we’re focused on the top 25 quartile, top 25% quartile of profits of cash in the balance sheets. Because with 49% of the world at vote this year, not just the us companies need to have the flexibility to. If politics are going to like a political change, in effect, an industry, you have the ability to be flexible and change that. And small and mid company, we see with negative earnings, when you have a negative earning cash flow, it’s very little flexibility of zero flexibility for not having to go cash.

So we don’t see this changing in the near future. We do see, as we go through cycles of early, mid, late and then recession, these factors can change. And we may go to the fact where we go back to normal, even heavier in small and mid captain, over that typical ten or 11% between the two. But for right now, we’re at about half because of these reasons. So, James, any other useful data that you’d want to point out?

Yeah, so I think it’s huge that there’s some political uncertainty around the world, like you said, not that we’re worried about who gets elected and what’s going to happen with the market, just these companies have to be able to shift based on policy changes.

Yeah. The s and P 500 is made up of all these different healthcare, financial, tech, all these different sectors. So on top of looking at just the factors we’re in, I mean, the difference of what makes up the s and P 500 versus small cap. Jameson, talk to us about that.

Yeah, I think it’s interesting. Right now, there’s more people over the age of 65 than under the age of 15. For the first time in history, we’re obviously about to see a huge. A huge wealth transfer with after world War two, the baby boomers. A ton of people were bored. Now those people are retiring. They’re post 65. 85% of the wealth in the United States is held by people over the age of 65. So if we look at what are those people going to spend money on? Healthcare is a big one. Absolutely. Technology obviously is a huge driver right now with AI and a lot of things that are going on with tech.

And so if you look at these indexes specifically, large cap is generally made up right now is more heavily weighted towards tech, healthcare, consumer discrete discretionary things that kind of play into that thesis of where the wealth’s at and what that money’s going to be spent on.

Which people are going to spend on healthcare and discretionary retirement. I mean, there’s a two they have to spend on health care and discretionary, they have the means to, whereas younger generation won’t have the means to do that.

Yeah, exactly. And then the small cap indexes right now have higher exposure in financials, industrials, energy, and those are things that are more cyclical. So I think bottom line is, it’s impossible to tell what’s going to actually win and what time period. Bottom line is be diversified. We can shift and tilt slightly based on macroeconomic trends. We never want to put all our eggs in one basket and say, okay, we’re going all large cap, it’s going to crush the next ten years. Because reality is nobody really knows you want to have that diversification. And the interesting thing too is especially with the smaller companies that can flip really quickly, these small cap companies are more volatile, so they could just take off like in the next year.

If these factors that we’re talking about change, then this isn’t a flip. We’re going to focus, interest rates go low, we’re in a recession now, we’re suddenly going to go back into a bull market, then we will want to favor the small and the mid.

Yeah. So important to not totally jump ship and avoid either of these completely. Be diversified and make sure you have all your baskets filled.

Absolutely. Well, thanks for joining us. Thanks for joining us as well. And we’ll catch everyone next week. Thanks for tuning in to our podcast. Hopefully you found this helpful. Really hope this is as beneficial and impactful to as many people across the nation as possible. So hit the follow button, make sure to rate the podcast and please share with any friends or family members that would also find this beneficial. Thank you very much.