In the stock market, it's all about big and small. That is, large-capitalization and small-cap stocks get most of the attention, while midcaps are often ignored.
But those overlooked securities, with market values typically between $2 billion and $10 billion, may represent an attractive investment opportunity, experts say.
"Now is a good time to buy midcap stocks," says Chris Cordaro, chief investment officer at wealth-management firm RegentAtlantic in Morristown, N.J. "You're getting a better valuation than large-caps, but you aren't taking as much risk as small-caps. Midcaps are very much like Goldilocks in this scenario."
The price-earnings ratio for the S&P 400 index (.IDX) of midcap stocks, based on earnings estimates for the next 12 months, stood at 13.4 as of Jan. 2, compared with 14.4 for the S&P 500 index (.SPX) of large-cap stocks and 14.2 for the S&P 600 index (.SML) of small-cap stocks, according to FactSet. That indicates midcap stocks may be undervalued.
Midcaps also are less risky than small-caps because they generally are more established and financially stronger than their smaller brethren. In addition, they offer more transparency and have stronger corporate governance and better trading liquidity than small-caps, says Shannon Saccocia, chief investment officer for Boston Private Wealth.
"A lot of small-cap companies are small-cap for a reason," she says. "They aren't destined to grow."
History on their side
In recent years, midcap returns have lagged behind those of small- and large-cap stocks—which is one of the reasons why midcaps are starting to look attractive, experts say. Over the 12 months through Jan. 2, the midcap S&P 400 returned negative 11.9%, compared with negative 5.2% for the S&P 500 and negative 9.1% for the small-cap S&P 600.
Over longer periods, however, midcaps offer a well-documented premium over large-cap stocks, according to Michael Hunstad, head of quantitative strategies for Northern Trust Asset Management. His research shows that the Russell Midcap Index (.RMCC) returned 8.46% annually over the 20 years through Dec. 31, compared with 5.62% for the S&P 500. Over the past 10 years, the Russell Midcap returned 14.02% annually versus 13.11% for the S&P 500.
Part of the reason for the midcap premium, Mr. Hunstad says, is that once companies are big enough to be large-caps, they have less room to boost revenue and profit. "It becomes steady-state growth just like a country's economy," he says. Midcaps, on the other hand, have plenty of room to expand.
And because midcaps aren't as widely known as large-caps, there are more undiscovered bargains to be had. "These are solid businesses, but not as widely trafficked in," says Eric Freedman, chief investment officer at U.S. Bank Wealth Management.
Much of the outperformance for large-cap stocks in recent years stems from the surging shares of major technology companies, such as Facebook Inc. (FB), Apple Inc. (AAPL), Google parent Alphabet Inc. (GOOGL), Amazon.com Inc. (AMZN) and Netflix Inc. (NFLX). But in Mr. Hunstad's view, many of these megacaps have been priced to perfection, meaning any blip in performance could send their shares lower. Indeed, some of those stocks already have dropped, he notes. "That means a resurgence in the midcap premium."
So how much of an equity portfolio should an investor have in midcaps? Midcaps account for about 18% of total U.S. and global-stock market capitalization, so investors can use that figure as a benchmark, says Christine Benz, director of personal finance at fund researcher Morningstar Inc. Consider allocating an equal amount to midcap value, growth and blend funds for diversification, she says. (Blend funds include growth and value stocks.)
But Ms. Benz cautions against going overboard on midcap stocks more than 9½ years into a bull market, pointing out that midcap and small-cap stocks tend to fare worse than large-caps in market selloffs. Midcap indexes lost about 5 percentage points more than the broad market in 2008, she says.
Morningstar gives several midcap mutual funds and exchange-traded funds its top rating of gold. That includes value fund Diamond Hill Mid Cap (DHPYX) and blend fund iShares Core S&P Mid-Cap ETF (IJH). Morningstar's silver-rated midcap funds include growth offering Vanguard Mid-Cap Growth ETF (VOT).
The Diamond Hill fund earned its gold rating "because of the depth of its bench and its disciplined, bottom-up approach," Morningstar analyst Linda Abu Mushrefova writes in a report. "The team conducts deep analysis to identify attractive companies trading at a discount to their estimated intrinsic value."
The iShares fund tracks the S&P 400 midcap index. But an S&P committee chooses the index's final holdings, "so it doesn't follow mechanical rules or a strict reconstitution schedule like many of its index peers," Morningstar analyst Adam McCullough writes. It also avoids recent IPOs and only considers adding profitable stocks, giving the fund "a stronger quality orientation than most of its category peers," he says.
The Vanguard fund "is a compelling option because it is one of the cheapest midcap growth funds available," writes Morningstar analyst Alex Bryan. It has an annual expense ratio of just 0.07%. "On top of its considerable cost advantage, it effectively diversifies risk and applies generous buffering rules to mitigate unnecessary turnover," he says.
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