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Mining the Small- and Mid-Cap Space for Value

Traders Magazine Online News, May 4, 2018

James Rife

The rise of passive investing continues to result in large-cap concentration on the buyside. Cost pressures continue driving sellside firms to cut coverage of small and mid-cap stocks that many might consider less likely to become “income-generators.” With MiFID II ahead, the trends seem unlikely to change for quite some time.

But there can be massive takeout premiums for small and mid-cap names in the market. Simply put, there is considerable and ever-increasing value in considering small and mid-cap stocks that many investors routinely ignore. Low interest rates and easy credit simply wouldn’t explain the positive performance.

However, the question remains. How do you access the information and mine the data for gems? The strategy demands access to a database with a massive breadth of coverage, including the usual and larger stocks, as well as the small and mid-cap space that is too often overlooked.

In this eBook, we will consider the missed opportunities for analysts, portfolio managers, directors of research, founders and CIOs in small and mid-cap stocks. Admittedly, it takes skill and discipline to identify underfollowed small and mid-cap names that are likely to outperform, but the effort may prove worthwhile.

An Active Approach

The argument for passive investing through index funds and ETFs reflects conventional wisdom. Index funds carry smaller fees, and ETFs provide tax efficiency, as well as lower operating costs. That’s been bolstered by a period of historically low interest rates since the 2008 financial crisis. However, the strategy may be a bit myopic in a time when stock correlations are weakening in a more volatile market. Small and mid-cap stocks have a place in a portfolio, along with risk-based allocation.

We can point to central bank intervention post-financial crisis for the flows to passive investments, but over the long haul, active investing still wins the day. Active investors are also set to benefit from rising interest rates and increasing volatility.

Today, active portfolios remain the bulk of assets, despite the outflows during the past few years. Total assets of actively managed funds totaled $11.4 trillion vs. $6.7 trillion for passive funds in 2017.  Indeed, some would argue that active investing is slowly making a comeback and that the large outflows of 2015 and 2016 are sure to subside.

There are signals that this could be the case. While passive investments continued to see a record level of inflows, Morningstar indicates active funds were close to breaking even in 2017. The performance of active managers is improving, which is a good sign, due in part to a drop in stock correlations.

So, when is the right time to position yourself for the potential reversal? Value investors make the case for tirelessly looking for stocks that the market has undervalued.

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