Large cap technology stocks have driven stock market returns in recent years and, despite briefly falling out of favour, this year appears no different as a wave of euphoria regarding artificial intelligence grips investors.
It is little surprise that the largest stocks in the S&P 500 are leading technology stocks. The seemingly unstoppable rise of Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta has earned them the title of ‘the magnificent seven’.
But are investment strategists and portfolio managers as enthusiastic as the market suggests? We spoke to three who favour large, mid and small caps beyond this elite group.
LARGE CAPS
Nuveen’s highest conviction within equities is large cap dividend growers, which tend to be less susceptible to stock market volatility.
‘While a relatively healthy economic backdrop should continue to provide ballast for equities, current prices likely already reflect a soft landing, which could open the door for increased volatility should economic data become less supportive of that narrative,’ says chief investment officer Saira Malik.
Historically, stocks with the highest payout ratios have not been the best long-term performers. The firm focuses not on absolute yield but on high quality companies with strong free cash flows capable of supporting a progressive dividend policy.
‘A firm’s dividend payout ratio is a key indicator of dividend policy flexibility,’ says Malik. ‘Companies earning just enough to pay dividends or paying most of their earnings as dividends have less capital to invest back into the business, which limits future growth opportunities that could threaten both share price appreciation and dividend growth.
‘Knowing where to look for quality companies is crucial. While dividend yields are higher outside the US, investors who focus too much on current dividend yield may overlook a wide universe of well-run firms with a history of growing dividends.’
History shows that these have outperformed the broad market over time. Global dividend payers with modest yields of up to 3% have better earnings growth potential, stronger profitability metrics and higher profit margins than higher- and non-yielding companies (see chart), ‘all of which tend to mitigate risk when volatility prevails’, she adds.
MID CAPS
7IM has equal exposure to the top 500 US stocks specifically to avoid concentration in the ‘magnificent seven’, which now account for one-third of the index (see chart).
‘Now, these aren’t bad businesses. They’re the opposite – Microsoft and Amazon aren’t going anywhere, and you’ll still be using Apple products in ten years’ time,’ says head of equity strategy Ben Kumar. ‘But they are likely to be bad investments.’
The firm has reallocated the gains made from the S&P 500 index over the last few years to the Xtrackers S&P 500 Equal Weight UCITS ETF.
‘You end up with loads invested in the mid-cap tail of the S&P 500 at the expense of underweighting the top 50 or so stocks,’ he says.
Mid-cap companies are cheap, largely profitable and, unlike certain areas of large caps, have room to grow.
‘One of the biggest threats to the magnificent seven is friendly fire. Their biggest competitors are increasingly one another – whether in cloud computing, devices or search.’
Historically, the equally weighted index has outperformed the size-weighted index by 1.5% per year, making it a sensible long-term allocation.
‘The best periods of performance come after a peak in cap-weighted index concentration, both through avoiding the pain on the way down and rallying on the way up,’ adds Kumar.
‘In 2000, the equal-weight index avoided the bubbly tech stocks. In 2008, it avoided the banks and real estate businesses. In 2023, we think mid-cap is starting to make a lot of sense again.’
SMALL CAPS
In a world where the focus is on inflation, one asset class has been getting cheaper – European smaller companies. That is despite them being exposed to global trends such as automation, healthcare innovation and energy efficiency.
‘It seems apt to explore this small-cap space of the market where investors can seek attractively priced assets that offer both protection in tough climates and increased capital appreciation over the longer term due to their structural growth exposure,’ says Phil Macartney, an investment manager in Jupiter’s European equities team.
Many European small caps, with a market capitalisation of €1-10bn, have global diversification, importance in their niche market and the ability to self-fund their growth, something that micro firms may struggle with in a tougher climate.
Often their more attractive long-term growth profile means small caps tend to trade at higher valuations than their large cap peers. Today, however, the premium is near zero (see chart).
‘These enterprises help their customers fight inflationary pressures, “keep the lights on” or allow innovation to occur at a quicker pace,’ says Macartney. ‘They tend to have high barriers to entry as evidenced by their know-how, patents, network effects and high switching costs, which gives them pricing power.’
Many have strong balance sheets, important in a rising rate world, and global products: ‘Good products will travel – the best products win on a global stage.’
Stocks he owns include Swiss headquartered Comet, a name critical for the next stage of microprocessor manufacture, and German oven manufacturer Rational.
