Why mid caps may lead the way out of recession

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.

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. 

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.

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 (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 mid-cap 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.