Why mid caps may lead the way out of recession

The dominant performance of mega-cap technology and growth stocks has led to concerns that this area of the market is overvalued. U.S. mid caps could be an attractive alternative for investors looking for lower valuations with the added kicker that they tend to perform well coming out of recessions.

mid-cap-stocks-recession

Laggard may become leader

The COVID-19 pandemic has dealt a big blow to the global economy—and smaller, riskier stocks have generally underperformed large caps in the United States. The large-cap Russell 1000 Index is up 10.5% so far this year, while the Russell Midcap Index is up 3.6%, and the small-cap Russell 2000 Index is down about 1%.¹

However, in looking for the most attractive opportunities for performance coming out of this recession, we’re drawn to mid-cap stocks. This group has done particularly well exiting the recession of 2001 and the financial crisis of 2008.

mid-cap-stocks-vs-sp500-index

The recent underperformance of mid-cap stocks has been the most extreme since 1998, possibly setting the stage for a rebound such as the ones seen after the previous recessions. We like mid-cap stocks exiting recession because they have the potential for substantial upside, but their businesses are more established than small caps. 

Finding value in mid caps

Although large-cap growth and tech stocks are where all the action’s been lately, we believe they’re relatively expensive. Mid-cap stocks, on the other hand, are often overlooked. We believe this is a mistake because mid caps may offer growth potential while being more mature than small-cap companies. And in terms of style, we currently like mid-cap value over growth.

Looking at valuations, the Russell 1000 Growth Index has a price-to-earnings (P/E) ratio of 37.9, which reflects upbeat expectations for large-cap tech earnings. The Russell Midcap Value Index has a much lower P/E ratio of 20.1.²

Investors should also be aware that sector allocations in mid caps can be different from large caps. For example, industrials are currently the largest sector in the Russell Midcap Index.³ This could be a way to position from a potential rotation away from tech to industrials.

Finally, mid caps may benefit from increased merger and acquisition (M&A) activity because they could be takeover targets by large multinationals.

Postrecession rebound?

We believe mid-cap value stocks may provide some diversification and opportunity for investors who want to participate in the U.S. postrecession recovery, but are worried about high valuations in large-cap tech stocks.

And because mid caps tend to be underowned and not as widely followed by Wall Street, we believe an active approach makes sense. We bring a value mindset to mid-cap stocks, with a three-circle approach to companies with attractive valuations, sound fundamentals, and catalysts for improving business momentum.

 

1 FTSE Russell, as of 10/9/20. 2 FTSE Russell, as of 9/30/20. P/E ratios exclude negative earnings. 3 FTSE Russell, as of 9/30/20.

Price-to-earnings ratio: Price to earnings (P/E) is a valuation measure comparing the ratio of a stock’s price with its earnings per share.

The Russell 1000 Index tracks the performance of 1,000 publicly traded large-cap companies in the United States. The Russell 2000 Index tracks the performance of 2,000 publicly traded small-cap companies in the United States. The Russell Midcap Index tracks the performance of approximately 800 publicly traded midcap companies in the United States. The Russell 1000 Growth Index tracks the performance of publicly traded large-cap companies in the United States with higher price-to-book ratios and higher forecasted growth values. The Russell Midcap Value Index tracks the performance of publicly traded mid-cap companies with lower price-to-book ratios and lower forecasted growth values. It is not possible to invest directly in an index.