Manager Insight - The Mid-Cap Advantage
By M. Scott Thompson, Co-Director of Research, Montag & Caldwell Investment Counsel
During the past 30 years, mid-cap stocks have consistently provided superior investment returns with less volatility than small-cap stocks. Through December 31, 2011, the Russell Midcap Index had outperformed the small-cap oriented Russell 2000 Index for the one-, three-, five-, seven-, 10-, 15-, 20-, 25-, and 30-year periods, with less volatility (as measured by standard deviation) and superior Sharpe Ratios (a measure of risk-adjusted returns).1 Perhaps more impressively, the Russell Midcap has beaten the Russell 2000 during every rolling 10-year period since 1978. This is notable as 10-year periods typically capture a full economic cycle of both recessionary and expansionary periods.
Unfortunately, we think many investors have missed out on that impressive track record. In our view, there’s a tendency by mutual fund investors to overlook mid-cap stocks when making their equity allocations. Typically, investors anchor their stock portfolios with large-cap stocks, for their perceived stability, while seeking more-aggressive growth among small-caps. Mid-caps are often an afterthought to be covered by the fringes of the large-cap and small-cap strategies. This approach, however, ignores the unique advantages of truly mid-sized companies and the combination of growth and durability that they can offer.
Market-Cap Sweet Spot
We view mid-cap stocks as being in the “sweet spot” of the market-capitalization spectrum, offering greater stability and safety relative to small-caps and superior growth over larger companies. Mid-sized companies tend to have already exited the early, high-risk stage of their life cycles and have entered a period of steadier, perhaps even faster, growth. Relative to small-caps, mid-caps have achieved a certain level of business success in having established their footprint in the marketplace. Yet they remain nimble, not plagued by the girth that can challenge the growth prospects of more mature firms.
Mid-caps are apt to be on more secure financial footing than small-caps as well, generating superior free cash flows that can be used to support growth—either through reinvestment in the business or through acquisition. Small-caps tend to carry greater financial leverage while struggling to generate excess free cash, thereby placing them at greater risk. In addition, mid-caps generally have less trouble accessing credit markets for needed capital. Stronger balance sheets and cash flow can provide better support during economic downturns, allowing them to not only survive, but thrive as they emerge from such periods in stronger competitive positions compared with smaller, weaker rivals.
As a result, we think mid-cap stocks can be viewed as an asset class for all seasons. They tend to outperform small-caps during periods of economic contraction and heightened risk aversion, and outperform large-caps during expansionary periods characterized by greater risk taking.
In today’s market environment we see a unique opportunity particularly for mid-cap growth stocks relative to their value counterparts. Following 10 years of outperformance by mid-value stocks (Russell Midcap Value Index) over mid-growth stocks (Russell Midcap Growth Index), we think most growth indicators are now trading at unusually attractive levels relative to value. The Russell Midcap Growth is presently at a 32% premium to its value counterpart on a price-to-trailing earnings per share basis, well below its 20-year historical average premium of 64%. Similarly, on relative price-to-sales basis, mid-growth is at an 85% premium to mid-value compared with a 20-year average premium of 111%.2
Simple mean reversion would suggest growth stocks have the potential to outperform going forward in order to drive relative valuations back to historically normal levels. We believe the current economic outlook presents the fundamental backdrop for this mean reversion to occur. A credit-constrained, slow-growth economy sets the stage for superior performance by those companies able to consistently deliver above-average earnings growth due to faster growing end-markets, an ability to fund growth internally, and a greater ability to increase market share (via unique product cycles and/or superior execution).
In this vein, we also think the current environment for mid-caps favors high-quality companies over more speculative businesses. The current market rally has been led by lower-quality stocks since the financial crisis bottom in March 2009. The stocks that performed the best in 2009 and 2010 were characterized by their initial low share price, small size, high beta (volatility relative to the market/benchmark), and low return-on-equity (ROE—a common measure of quality based on a firm’s efficiency in generating profits for each unit of net assets). In general, it was low-quality stocks that declined the most during 2008 and the first two months of 2009.
It is our belief that the economy has exited the speculative recovery phase of the economic cycle, when lesser quality stocks tend to do better, and has entered what we expect will be a more enduring, albeit slower growth, expansionary phase more conducive to quality firms. Due to the ongoing deleveraging of the household, financial, and public sectors of the economy, along with anticipated higher taxes and increasing government regulation, we expect this expansion will be halting and uneven at times and generally below par. As a result, we expect investors to seek out the stocks of companies that can deliver sustainable growth. Indeed, we saw evidence that this rotation to higher-quality began in 2011.
We believe those companies that are able to consistently deliver double-digit earnings growth over the course of a full cycle and those able to generate superior returns on capital with low levels of financial leverage will be rewarded with premium valuations going forward. We think such a return to favor for high-quality growth is particularly suited to Montag & Caldwell’s approach to picking mid-cap stocks.
1 Source: Russell Investments and Third Party Performance Measurement Software
2 Source: FactSet
The information contained in this article is provided by Montag & Caldwell Investment Counsel (“Montag & Caldwell”), a subadviser utilized by Aston Asset Management, LP (“Aston”). Montag & Caldwell is not an affiliate of Aston and their views do not necessarily reflect those of Aston.
This material is not intended to be a forecast of future events, does not constitute investment advice, and is not intended as a recommendation to buy or sell any security. Investors should consult their investment professional regarding their individual investment program. Since the date of this report, economic factors, market conditions and Montag & Caldwell views of the prospects of any particular investment may have changed. Investors should consider the investment objectives, risks and associated costs carefully before investing. Forward-looking information is subject to certain risk, trends and uncertainties that could cause actual results to differ materially from those predicted. Past performance is no guarantee of future results. For more information about Aston Asset Management, LP and its subadvisors, please call 800-597-9704, or visit www.astonfunds.com.or visit www.astonfunds.com.