The reality is that we now live in a world where mega-cap stocks dominate the mind share of most investors. There are good reasons for this. In the stock market, size matters. And when regulators continue to approve mega-sized mergers, the largest companies that are already benefiting from scale can benefit even more from less competition.
That’s a win for corporations, but perhaps less of a win for consumers. And when the pandemic hit, and many companies shut down for good, we saw this entire ordeal balloon by orders of magnitude, leading to a surge of inflation we haven’t seen in decades.
So, with the largest companies getting even larger (both in size and market capitalization), is there ever any hope for the little caps? I think so.
The thesis
My overarching thesis around the rise of the small to mid-cap stock for the next decade or two really boils down to the idea that overall size can be beneficial in the near-term, but typically ends up the same way over the very long-term. As companies get bigger, it simply gets harder and harder to grow (without those mega-sized merger and acquisition deals I nodded to earlier).
So, assuming the laws of finance still hold true, larger companies should, in theory, grow at a slower pace than those starting out. That’s what most pro formas will tell us, and what most investors who can think conceptually about growth rates will tell you.
Now, the artificial intelligence revolution and other catalysts may have disrupted this trend, at least for a bit. That’s because some of the largest companies out there with the biggest pockets have the ability (or the perceived ability) to corner the market on this nascent and seemingly invaluable technology. If that’s the case, maybe small caps are doomed.
I’m just an old-fashioned thinker, when looking at stocks as the sum total of their discounted future cash flows. On that basis, I’d make a bet that a well-diversified portfolio of small-cap stocks will outperform the mega-caps by a decent margin over the next two decades.
So, where to invest?
As mentioned, I’d focus on a well-diversified portfolio of small-cap stocks, if I’m looking at them at all. That’s because while larger companies tend to grow at a meaningfully slower pace than those on the bottom decile in terms of size, it’s also true that small caps are far riskier than mega-cap names, and tend to go bankrupt at a rate that’s orders of magnitude higher than large caps.
With this in mind, I’d focus on investing in a broad-based exchange-traded fund basket of small-cap stocks, and nibble around the edges with a few I’m excited about. That keeps us interested in the game, and that’s part of what it’s all about.
