Investment Value In U.S. Mid-Cap Stocks

By M. Isi Eromosele

During the past 25-year period, U.S. mid cap stocks have outperformed their large and small cap counterparts. Yet, many institutional portfolios still maintain a relatively low allocation to this asset class.

Long-term investors should reconsider the role of mid cap stocks in a well diversified portfolio because they may offer distinctive features large caps and small caps do not.

For example, on a historical basis, the U.S. mid cap sector has offered meaningfully higher excess return potential than the extensively researched world of U.S. large caps. At the same time, mid caps have historically exhibited less volatility than their small cap counterparts

The Investment Value In U.S. Mid Cap Stocks

U.S. mid cap stocks and their associated companies offer distinctive features that set them apart from other capitalization ranges, including:

• Better diversification of business operations relative to smaller companies
• Deeper management resources than U.S. small cap companies
• Less volatility and more moderate downside risk than small cap stocks
• More operational experience than many younger, small cap companies
• Potentially more apt to benefit from new product growth and market share gains than larger cap companies
• More nimble than large cap companies, with greater flexibility to remedy problematic divisions
• Outsourcing allows mid cap companies to “punch above their weight”
• Since 2001, mid cap companies have shown better margin performance than small companies along with faster earnings growth than large companies

The U.S. mid cap universe remains an inefficient and under-researched sector, since Wall Street coverage is far more limited for U.S. mid caps than for U.S. large caps. Investment management firms often specialize in U.S. large cap or U.S. small cap equities, with minimal emphasis on expertise in the U.S. mid cap asset class.

Amid this limited analyst coverage, greater market inefficiencies exist in the valuations of the U.S. mid cap universe than for other market cap ranges. This helps explain the outperformance.

Even after the recent U.S. equity market volatility and the strong performance run of large cap stocks, mid caps have remained the long-term return leader. Indeed, mid caps have outperformed small caps by 186 basis points since the launch of the Russell indices 33 years ago.

Strong Performance in Variable Markets

Critical to the strong, long-term returns of mid cap stocks has been their ability to provide solid relative performance in up and down market environments.

Mid caps have delivered competitive returns in rising markets, but more importantly, declined only slightly more than large cap equities in down periods and not nearly as dramatically as small caps.

Risk/Return Trade-Off

For many investors, the excess return generated by mid caps over large caps may be an acceptable trade-off for higher volatility. It is also important to note that part of the increase in standard deviation (a measure of volatility of the return stream) is also a function of the higher excess returns delivered over the represented time period.

Earnings Growth for Mid Cap Companies

The period of early 2000s appears to have laid the foundation for mid cap companies to achieve new levels of margin performance and earnings growth. Responding to the challenges of the recessionary environment, mid cap companies expanded the use of outsourcing to cut production costs without the expense of large capital spending programs to gain scale.

The deflationary impact of the Internet revolution, the plunge in technology hardware costs and the productivity enhancements driven by continuing technological advancements had an immediate and long-lasting effect on mid cap profit margins.

Scalability, increased product diversity and broader exposure to global markets have also enabled mid cap companies to deliver higher pre- and after-tax margins than their small cap competitors.

Large cap companies had already attained benefits of scale, technological advancements, geographic expansion, market share penetration and attention to costs, so progress from already high levels was more difficult.

In addition, large companies offer more mature products and face the challenge of demonstrating meaningful growth off a much bigger operating base. Even though large companies demonstrated 16.4 percent earnings-per-share growth over the past 10 years, the combination of limited margin expansion and mature products produced a growth rate that meaningfully lagged mid cap results. Mid cap companies delivered an EPS growth rate 680 basis points higher than large caps.

Compelling Mid Cap Valuations

After the recent market turbulence, valuations for small, mid and large cap domestic asset classes have become quite compelling. The more stable valuation metrics, such as price-to-sales and price-to-book ratios indicate attractive opportunities for most U.S. equities.

On a price-to-sales basis, each asset class is generally valued around one-time sales. The price-to-book ratio is also attractive for each class. Whether domestic equities will be attractive on the more volatile P/E and P/E-to-growth metrics hinges on the status of the U.S. economy as 2012 progresses.

Assuming the U.S. does not experience a recession in 2012, all equity classes appear to be undervalued on 2012 P/Es and their respective P/E-to-growth ratios.

However, with valuation metrics so close across each asset class and the 2012 outlook somewhat uncertain, it makes sense to consider mid caps and the higher reward-to-risk ratio they have demonstrated over time.

Why Mid Caps?

Mid cap stocks are an important component for long-term investors seeking diversification and attractive risk-adjusted returns. Mid cap stocks have historically outperformed their large and small cap counterparts.

This is a positive reflection of the stocks and companies that comprise this universe, and reflects the inefficiencies in this space that can be exploited by skillful managers. In the current low growth environment with potentially modest market returns, mid caps could provide the additional capital appreciation many investors seek.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Copyright Control © 2012 Oseme Group