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Small-Cap & Mid-Cap Stocks Require a More Selective Approach

By Richard "Crit" Thomas, CFA, CAIA
U.S. Equities
dominos in a row

Credit Risk & Slowing Economic Growth

Credit risks have surrounded the dramatic rise in low-quality debt during this economic cycle. Low interest rates over the course of the cycle have spurred business borrowing, especially at the low end of the credit spectrum. These higher levels of debt now appear more ominous given a backdrop of slowing economic growth amid rising business costs (fueled mainly by higher wages and tariffs).

Economic growth is expected to slow in 2019 and again in 2020 as the boost from fiscal stimulus wanes and the negative effects from tariffs build. In a recent survey by Duke’s Fuqua School of Business, 69% of U.S. CFOs predicted a recession by the end of 2020.1 The same group cited difficulty in hiring and retaining qualified employees as their leading concern.

Where Credit Risk Lives In Equities

High yield and leveraged loan debt outstanding — on an absolute basis as well as relative to measures of cash flow generation – have surpassed all past peaks. Notable for equity investors is that lower-rated companies tend to be smaller in size. As such, it shouldn’t be a surprise that the net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization — a rough measure of cash flow) ratios for the S&P MidCap 400 and S&P SmallCap 600 indexes have risen to all-time highs. For comparison, by the same measure, the S&P 500 index remains near all-time lows (see accompanying chart).

SMID and Credit Risk ChartSource: Bloomberg

Even more notable, in the event of a default, equity investors are the most at risk as they sit lowest in the capital structure. Yet the broad strokes of index-level analyses miss the underlying differences among the index constituents. While a large and growing contingent of companies have contributed to the higher ratio of net debt to EBITDA for the indexes, we believe there continues to be a large opportunity set of mid- and small-cap companies, ones either with no debt or which carry a reasonable amount of debt, for investors to consider.

The Small- & Mid-Cap Opportunity

We don’t see these high debt levels as a reason to avoid or underweight small- and mid-caps, only their representative indexes. We favor an emphasis on active management where there is the potential to mitigate these risks while maintaining the return and diversification benefits of these asset classes.

1 Duke CFO Global Business Outlook, “CRO Survey: Global Recession Predicted; Strong Support for U.S. Immigration Reform,” June 11, 2019.

This commentary is for informational purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security. There is no guarantee that the information is complete or timely. Past performance is no guarantee of future results. Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Please visit touchstoneinvestments.com for performance information current to the most recent month-end.

Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.

Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.

Not FDIC Insured | No Bank Guarantee | May Lose Value

crit thomas global market strategist

Richard "Crit" Thomas, CFA, CAIA

Global Market Strategist
Crit is responsible for examining and evaluating economic conditions, generating insights and providing a sharpened perspective on investment strategies for enriched portfolio construction.

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