Most retail investors have at least a casual understanding of the various stock indexes and the type of companies that compose them. The most widely recognized indexes are the Dow Jones Industrial Index (Dow), the S&P 500 Index from Standard and Poor's, the Nasdaq Composite and the Russell 2000. Each consists of U.S. listed companies with slightly different requirements such as revenue and average daily trading volume, but the concept we’ll primarily cover below is Market Capitalization, or “Market Cap.”
The Dow tracks 30 massive companies that are listed on the New York Stock Exchange the the Nasdaq, whereas the Nasdaq Composite tracks approximately 2,500 companies that are listed on the Nasdaq exchange and are heavily weighted toward the technology sector. The S&P 500 tracks mostly large companies, many of which are also members of the NASDAQ and Dow, while the Russell 2000 is composed of smaller companies.
Because the Dow is a narrow index of only large companies and the Nasdaq Composite is technology heavy, many investors look to the S&P 500 and the Russell 2000 as indicators of performance in the broader U.S. economy.
Investors can mirror the investments and therefore performance of an index through passive investment vehicles such as an Exchange Traded Fund (ETF) that can be purchased in the same way one purchases an individual stock at any time during a trading cycle. This differs from mutual funds, which are similarly designed, but traded based upon their closing value on a given day.
Each year the indexes are “rebalanced” to fit the individual index requirements such as market capitalization, which we will explain in more detail. It should be noted that every company on the aforementioned indexes is considered to be based in the United States, though many of the larger companies derive revenue globally.
Below we will explain the formula for capitalization (cap) and cover the threshold for small cap, mid cap and large cap. First, we will look at the index that best represents the small and mid cap sector.
We’re covering the Russell 2500™ because it’s the most widely used benchmark for strategies that are in the small- and mid-cap space. Commonly referred to as “SMID” the Russell 2500™ is designed to give a thorough look at the performance of companies that best represent their respective sectors, which is why it is commonly referred to as a bellwether for the U.S. economy as a whole. In fact, the primary rationale behind the Russell 2500™ rebalancing annually is to “ensure larger stocks do not distort the performance and characteristics of the true small to mid-cap opportunity set.”
FTSE Russell, the parent company that provides the data for this and other indexes and a wholly owned subsidiary of the London Stock Exchange Group, established the Russell 2500™ in 1990. The most recent data as of this publication (March 2021) show that the Russell 2500™ has returned an average of 12.27% over the past ten years. Further, it currently has an average market cap of $7.2 billion and median market cap of $1.5 billion. The largest stock in the index has a market cap of $38 billion.
It’s also a broad index as compared to the Nasdaq Composite, for example, as it represents a wide cross section of sectors in the U.S. Economy, including:
Market capitalization is a measure of the market value of a company, not the size of its balance sheet or revenue. Essentially it is determined by the current price per share multiplied by the total outstanding shares. Market capitalization is often quoted by asset and portfolio managers as well as financial analysts and pundits and is therefore a simple and important term to understand. When companies like Apple, for example, might be in the news as having exceeded a $2 trillion value (this is an example as this figure will fluctuate daily) even though its revenue is around $260 billion, it essentially refers to the current market capitalization figure.
Below is a very general overview of market capitalization by category and which indexes fall within these categories.
Small Cap. Companies with a market capitalization between $300 million and $2 billion are generally considered small cap.
Mid Cap. Companies with a market capitalization between $2 billion and $10 billion.
Large Cap. Companies that exceed $10 billion in market capitalization.
Note: Though not as commonly referenced, some institutions will refer to “mega-cap” companies that have a market capitalization of more than $200 billion, “micro-cap” companies with a market capitalization between $50 million and $300 million, and “nano-cap” companies with a market capitalization under $50 million. Again, these aren’t quoted nearly as often as the others because of their relatively small size and/or impact on investment strategies.
With an understanding of market capitalization and where a company falls along the spectrum of categorization, let’s briefly revisit the top indexes.
Dow Jones Industrial. Although we just finished reviewing capitalization as a concept, one area it doesn’t directly apply in terms of valuation is the Dow. The Dow is not calculated on a weighted average like other indexes. Rather it is valued by an absolute value of the share price for each company listed on the index divided by an established “divisor” that is publicly monitored and can sometimes change in order to maintain a relative value over time. This might happen, for example, as a result of a stock split. So while the valuation calculation differs from the other weighted indexes, the approximate value of the companies listed on the Dow exceeds $8 trillion.
Nasdaq Composite. The Nasdaq Composite tracks performance of 2,500 U.S.-based companies and includes equities as well as other investment types such as REITs. It is a market-weighted index composed mostly of technology companies. It also rebalances regularly and has an approximate market cap of more than $20 trillion.
S&P 500. Tracking approximately 500 of the largest companies in the United States, the S&P 500 has become the most oft-quoted index and broader indicator of economic health and stability within the investment community. There are thousands of strategies and funds that closely track the S&P 500, which has an approximate market capitalization of $32 trillion.
Russell 2000. As discussed above, the Russell 2000 tracks the smaller end of publicly listed companies and represents slightly less than 10% of the total U.S. equity market. The aggregate market capitalization of the Russell 2000 is approximately $1.2 trillion, according to the most recent rebalancing.
The Russell 2500™. Interestingly, the Russell 2500™ market capitalization is generally quoted as a subset of the larger Russell 3000, a weighted index of more than 3,000 companies with an aggregate market capitalization of more than $13 trillion. You can see the massive influence of the larger companies in the index given the Russell 2000 has a market cap of approximately $1.2 trillion. Because the 2500 adds 500 or so mid-cap companies to the small cap 2000, it obviously increases the market cap of the 2500 but it still doesn’t approach the overall value of the 3000 due to the outsized impact of the largest U.S. companies. Typically the Russell 2500™ market cap is expressed as a percentage of the Russell 3000, which would theoretically place its capitalization at around $2.5 trillion.
Using the Russell 2500™ as our benchmark for a small and mid cap strategy, we can examine the philosophy behind blending small- and mid-cap investments and distinguish between the passive strategies such as ETFs and Mutual Funds and what is known as an “active share” strategy. It’s important to note that there is a distinction between active share and active management. Active management involves constructing a portfolio that is not attempting to mirror index weights of stocks and/or sectors. Active share the measure of how different a manager’s portfolio is from the index.
Passive management involves the purchase of an instrument designed to simply replicate the performance of an index by owning the same holdings in the same weighting. If you have heard the phrase, “hugging the benchmark,” that’s essentially what this means.
The reason someone would consider investing in a small- and mid-cap strategy is to diversify the risk associated with one or the other. A strictly small cap strategy means that your assets are betting on smaller companies performing well under any market condition, which is often not the case. Smaller companies have less access to capital and tend to have more competition, making them more subject to risk in a volatile or down market environment.
Mid cap companies tend to offset this type of risk though as one moves up the ladder, so-to-speak, the gains become increasingly difficult to achieve because there are fewer companies in this spectrum. But mid-cap companies do tend to have deeper pockets and have demonstrated an ability to break out of the extremely competitive nature at the lower end of the market.
This is, of course, a broad generalization. There are many investors who favor small-cap companies because there are fewer analysts in the mix on individual companies and therefore a greater opportunity to find so-called “diamonds in the rough.” Small-cap companies that outperform the market and grow revenue quickly can be exciting to track.
The point of a blended strategy that is more actively managed is to find those “diamonds” that can outperform the market, while mitigating risk with slightly larger companies that will be less volatile.
While there are quite literally thousands of strategies that both actively and passively benchmark to the well-known indexes discussed above, small- and mid-cap strategies are less prominent.
The Small and Mid Cap Opportunities Strategy appeals to investors seeking exposure to small- and mid-cap equities, where diversification is critical but is not determined by index weights. The portfolio is composed of dynamic companies from all sectors of the economy. The ability to consistently execute at a high level, outperform its peers and generate cash are all hallmarks of the equities we select.
The Small and Mid Cap Opportunities Strategy seeks to generate risk adjusted returns over the long-term. For investors who seek exposure to equities and want to diversify beyond large caps, but are hesitant of the risk associated with small-cap equities, this portfolio is an essential element of an equity strategy.
The Hilton evaluation process follows rigorous standards to invest in companies with strong corporate fundamentals, not simply sectors or trends. Our team is focused on achieving returns with less volatility and offering exposure to solid U.S.-based companies led by experienced and high quality strategic managers. /p>
While our process is certainly value-oriented, we investigate stocks across the value and growth spectrum. Typically we hold between 50 and 75 stocks, with a minimum of 75% of the holdings in the market capitalization range of the primary index, the Russell 2500™.
“Managing between 50 and 75 positions,” explains Portfolio Manager Tom Maher, “is intense but I’ve found it to be a sweet spot. It’s narrow enough to allow for incredible depth of insight and knowledge into all of our key positions and broad enough to shed risk through diversification.”
“There are certain times when our investments live primarily in the small-cap range because of the increasing market capitalization, but this tendency reduces when the index rebalances,” continues Maher. “Our benchmark is the Russell 2500™ as it is the standard bearer for small- and mid-cap indexes. Every security we own is a listed security that follows uniform requirements for transparency so investors are never concerned with opaque reporting that can sometimes accompany over the counter (OTC) stocks.”
The Small and Mid Cap Opportunities Strategy at Hilton Capital Management is managed by Tom Maher, who joined Hilton to launch the strategy in 2019. Prior to joining the firm he was the portfolio manager of the smid cap, small cap and micro cap value equity strategies for Lord Abbett. Mr. Maher began his investment career in 1989 and worked at several high profile firms such as Lynch & Mayer, Inc, Centurion Investment Group, L.P. and Invesco. Mr. Maher joined Lord Abbett in 2003 and he was made Partner in 2010. Mr. Maher received a BS from Georgetown University and an MBA from New York University.
Throughout his career as a portfolio manager, Thomas Maher has been attracted to value and maintained a rigorous focus on company fundamentals. He attributes his long-term success in small and mid cap investment strategies to “rigorous research and a disciplined approach.” These characteristics demonstrate great philosophical alignment between Mr. Maher and the Hilton Capital investment team.
To learn more about the Hilton Small and Mid Cap Opportunities strategy, view the video below. To speak with a member of the Hilton Capital Management investment team, connect with us here