While U.S. small stocks have historically outperformed their large-cap peers, the small and mid-cap categories have lagged blue chips in recent years – as well as during the current bear market. Are small and mid-cap stocks poised for a breakout after the market downturn?

“Currently in the market, we see a number of companies whose shares have been extremely punished due to the overall weakening in the economy, as well as the change in interest rates,” explained Chad Miller, Thrivent Senior Portfolio Manager.

“Within a long-term context, we know that those small- and mid-sized companies are likely to be the ones that lead the recovery on the other side of the economic downturn. That’s why this downturn may present a unique opportunity to get invested in an attractive long-term asset class that can ultimately rebound and generate strong returns for clients.”

Even before the recent sell-off, valuations of small cap stocks had already dipped well below large caps – and those valuation spreads widened even further during the bear market of the past few months. The forward price-earnings ratio of the S&P 500^® was about 17 at the end of August, while the S&P SmallCap 600^® Index and the S&P MidCap 400^® Index were both about 12.

“As we tie that back to the valuation spreads that we utilize to inform where we look for opportunities, we've seen those valuation spreads become wider,” Miller noted. “As a result, some of those growth companies in the small and mid-cap space are becoming even more attractive relative to their large cap peers,”

While small and medium-sized companies often offer solid growth potential, they often have greater price volatility, lower trading volume, and less liquidity than larger, more established companies.

Looking for opportunities

While analysts can’t predict how the performance of smaller cap stocks will shake out in the near term, Miller does see the potential for strong gains over the long term.

“We have no way to predict what happens in the macro economy, so we shouldn't be overly focused on the short-term concerns that are happening in the economy. But we do have a way to assess and analyze the long-term opportunity in individual stocks.”

“We believe small and mid-sized companies certainly offer an attractive investment opportunity over the long term,” added Miller. “Assuming that we will return to some type of baseline growth over the long term, we consider the current down market as an opportunity to invest in smaller companies with solid long-term fundamentals to create strong returns for our clients over the next five to 10 years – rather than the next one or two quarters that are inherently unpredictable.”

Looking for long-term prospects

Miller is particularly interested in companies that are focused on environmental issues, such as emission reduction strategies and water usage and biodiversity solutions, as well as companies that develop circular business practices.

One company that fits that narrative is Advanced Drainage Systems, which produces plastic piping for the construction industry. “What they do uniquely is they're able to take recycled plastic, reformulate it, package it down in their facilities, and come up with a better product for the end user,” explained Miller. “They’re creating a virtuous circle by taking plastic out of the environment that would have been going into a landfill and feeding it back into their product portfolio. At the same time, they’re creating jobs for the local communities while displacing concrete, which is extremely emissions intensive.”

Miller believes that investing in small and mid-cap companies at their current depressed valuations could pay off well over the long term. “If we're able to identify companies that have sold off in the current market downturn that are eventually going to be the ones that solve some of the larger challenges we see in the world, we believe that represents a great buying opportunity.”