Mid-cap stocks often combine the growth potential of a young firm with the financial stability of a company that's survived beyond its early years. Yet many investors tend to overlook this compelling segment of the equity market.
Even though some investors tend to focus on big companies with household brands and products they use every day, U.S. mid-cap stocks held their own against their large-cap peers in 2019. The Russell Midcap Index was up 30.5% in 2019, only slightly trailing the 31.4% gain posted by the large-cap Russell 1000 Index.¹
Yet looking back further, an investment in mid-cap stocks over the past 25 years would have outperformed both large-cap and small-cap stocks while also generating a higher risk-adjusted return.
U.S. mid-cap stocks generally have less exposure to international markets than large-cap companies, which may provide some insulation to global trade and geopolitical tensions in 2020. Meanwhile, they've historically experienced less volatility than small-cap stocks.
Missing mid caps
Despite their superior risk-adjusted returns over the past quarter century, investors are underweight U.S. mid-cap stocks relative to their proportion of the overall market.
The average U.S. investor has 12% in mid-cap stocks—less than the 17% that the segment makes up of the overall market—based on market capitalization.
Investors aren’t the only ones who have a blind spot when it comes to mid-cap stocks. Wall Street often overlooks this asset class; for example, there isn’t really a set definition of what constitutes a mid-cap stock in terms of the range of market capitalization (size).
Many individual and professional investors tend to focus on large- and small-cap stocks. We believe this makes the mid-cap market less efficient, providing more opportunities for active managers. Also, it’s important to remember that a blend of large- and small-cap stocks tends not to behave like mid caps, which have their own unique characteristics. In other words, an allocation to large and small caps is much different from a position in mid caps.
Our approach to investing in mid caps
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.
Although we look for stocks that are inexpensive relative to their long-term history or competitors, our focus on solid fundamentals and quality means we generally avoid the cheapest or deep value stocks. Generally, we're looking for companies that are creating shareholder value over the long term, and we tend to hold stocks for years, so we aren't active traders. However, we'll sell a stock if it no longer satisfies any one of the three circles of our approach.
Among sectors, we like financials, technology, and industrials at this point in the economic cycle. Conversely, we're less positive on high-dividend, defensive sectors such as utilities, real estate investment trusts (REITs), and utilities, in part due to what we see as expensive valuations.
Putting it all together, we believe mid caps remain a compelling but overlooked segment of the market that warrants a place in investors’ portfolios in 2020 and beyond.
1 FTSE Russell, as of 12/31/19.
Standard deviation is a statistical measure of the historic volatility of a portfolio. It measures the fluctuation of a fund's periodic returns from the mean or average. The larger the deviation, the larger the standard deviation and the higher the risk. Sharpe ratio is a measure of excess return per unit of risk, as defined by standard deviation. A higher Sharpe ratio suggests better risk-adjusted performance.