'Neglected' Small and Mid-Cap Stocks Could Shine in AI's Shadow

Caught up in the large-cap artificial intelligence craze, investors have neglected their smaller brethren, which could stand to benefit from the trend

Yan Barcelo 9 July, 2024 | 9:24AM
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It's been a rough ride for small- and mid-cap stocks over the past few years. Since February 28, 2021, Morningstar US Small-Mid Cap Extended Index gained 14.32%, compared to 45.85% gained by Morningstar US Large-Mid Cap Index. To some, that means small caps have room to run.

At the end of May, while large-cap stocks traded at fair value, "US small-cap stocks were the most undervalued compared to their long-term fair value, offering approximately a 20% discount to fair value," says David Sekera, chief US market strategist at Morningstar. Mid-cap stocks stood somewhat at a middle point, offering a 7% discount, he adds.

The area with the largest discounts, at 25%, was value stocks, Sekera continues, while growth and core stocks, at 16% discount, offered a higher growth rate, but with much richer valuations. His conclusion: "based on those discounts, investors should be overweight small-cap stocks" in their portfolios.

Small-Cap and Mid-Cap Stocks on Sale: Managers

It is a conclusion other portfolio managers support. However, they find opportunities not only in the US but globally. Considering the cash that they generate, small- and mid-cap stocks look undervalued, asserts Kent Chan, equity investment director at Capital Group: "that holds in emerging markets as well as in advanced markets."

Over in Canada, Jeff Mo and Samir Taghiyev, portfolio managers of Three-Star, Bronze-Rated Mawer New Canada A fund, are just as confident: "we look for high-quality attractive companies, and we find that mostly in small- and mid-caps."

Why smaller stocks are so neglected may be due to the influence that Nvidia (NVDA), mega-caps and the AI narrative exert on the markets, says Chan. He also points to another feature: "so much liquidity has been flowing to the US, to the US dollar and the US bond market. With increased liquidity, you increase animal spirits, and liquidity-driven markets take time to shift."

AI Spilling into Small- and Mid-Cap Stocks

Since AI forms the overarching theme of investment markets, it's interesting to note how important a contribution small- and mid-cap players will bring, a contribution often overlooked, Chan believes. Behind Nvidia, he points out, "there’s data security, data organisation, and those tend to lie with small companies."

Thus he finds attractive names such as Taiwan's Global Unichip Corp. (3443), which designs chips and outsources their manufacturing to Taiwan Semiconductor Manufacturing Company (TSM). Another player, eMemory (3529), also designs chips, but in their memory component, with the specific aim of shrinking the chips to save energy in AI's insatiable hunger for it.

Taghiyev also looks into the AI narrative, outside the usual story of the mega-caps. That leads him into IT consultancy, and more specifically into Canada's Softchoice (CFTC.TO), a classic information technology reseller that has turned toward AI to help corporations design AI for their databases and implement it in their operations.

"It is Microsoft's largest partner and Amazon relies on Softchoice to understand the end needs of clients," Taghiyev states. "No matter who wins the AI race, Softchoice has a relationship with clients and the winners will all come to it."

Jeff Mo also has an eye on IT, but totally outside the AI narrative, in Match Group (MTCH), the largest online dating platform. After a powerful surge in its business during covid, activity has dwindled, Mo recognizes, "however, he adds, over the long term, especially outside the US, there’s a long runway for dating applications."

India is The New China for Small Caps

For Chan, India is the coming land of plenty and he thinks that it will replicate the evolution of China's phenomenal growth. In the 1990s, he recalls, China was investing heavily in major infrastructure projects like deep water ports and railways, as India is presently doing.

Then, China successively went into textiles, consumer electronics, and smartphones, and today is competing in smart drug design and electric vehicles. It could now be India's turn and "it has the scale to match China in terms of labour," Chan says.

For the time being, the Capital Group manager finds opportunities in very basic manufacturing companies whose fortunes are linked to India's infrastructure drive, notably Larson & Toubro (LTOD), "[which is] probably the most well-established infrastructure company in India," and in Tube Investments of India (TIINDIA). "We're so focused on technology, but when we think of reshoring, a lot will be old-world industry," he adds.

That's exactly what Samir Taghiyev finds in Montreal's Stella-Jones (SJ), an infrastructure pole and railway tie manufacturer, a company that could hardly be more "old world" and which I wrote about recently. The company has a leading position in the replenishment of North America's overstressed electric pole network and should find increased vigour in the growth of the EV market.

The Capital Group and Mawer portfolio managers are bottom-up stock-pickers, so they don't first identify promising sectors and then look around it for gold nuggets. They seek out value anywhere they find it, and Taghiyev and Mo are keenly attuned to companies "that have a sustainable wealth creation track record with returns above the cost of capital," Taghiyev notes.

Small-Cap Growth Stock Opportunities Outside AI

With that lens, the managers find value in many areas – all outside the AI box. For example, Kent Chan has invested in Lotus Bakeries (LOTB), a Dutch biscuit maker whose stock is up over 300% in the last five years, and which he identifies as one of those "slow and steady compounders" he favours.

Jeff Mo is evolving along similar paths. He has discovered a attractive stock in Munich-based Pathward Financial (FM7), a player in the heavily challenged sector of regional banks.

Pathward stands as one of two dominant players in the very elaborate market of pre-paid cards. The money on those cards has to go somewhere and 33% of it lands in the bank's deposit accounts on which it pays a much lower interest than traditional banks, notwithstanding a processing fee it charges.

Many of the companies outlined by the portfolio managers are overlooked by the market; is there not a danger that they will simply continue to linger in the shadows. It's not something Samir Taghiyev worries about, citing Benjamin Graham:

"In the short run, the market is a voting machine, but in the long run, it is a weighing machine." Taghiyev adds: "since we focus on wealth creation companies, and every day they create more, if the market recognises that, you do well. If it doesn't, we still do well. But when companies are performing well, one way or the other, markets will agree."

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Yan Barcelo  is a veteran financial and economic journalist with more than 30 years of experience

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