Greater volatility in mid-cap stocks may scare some investors away, but a strengthening of the U.S. dollar along with tariffs may make these companies a good strategy for diversification.
The stocks of mid-sized companies can offer higher rates of return compared with large companies that are not able to grow as quickly, says Greg McBride, chief financial analyst at Bankrate.com, a New York-based financial data and content company.
The catch is that mid-cap stocks tend to be more sensitive to interest rate changes and the economy. Investors who are seeking that higher return will have to tolerate greater volatility.
Mid-Cap Stocks Can Diversify Your Portfolio
Investors who favor large-cap stocks in their portfolios could diversify by adding mid-caps stocks, experts say.
“Limiting your U.S. stock exposure to the S&P 500 means you’re capturing only the top 70 percent of U.S. market capitalization,” he says. “By missing out on the bottom 30 percent of market capitalization, you’re also missing out on the fastest-growing companies in the U.S. market.”
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Large caps are preferred by investors because of lower risks and income gains while small caps are selected for high growth in capital gains, says K.C. Ma, director of the Roland George Investments Program at Stetson University in DeLand, Florida.
“Large caps will only do better around turning points, during uncertainty, early and late stages of a bull cycle and a bear cycle,” he says. “The risk-return performance will be just like owning the S&P 500, but without the large upside of small caps.”
Ma adds that since large, mid and small caps do not rise or decline together all the time, investors who chose to include all the caps in a portfolio will see a reduction in volatility.
Mid-cap stocks, which range from a capitalization of about $1.6 to $6.8 billion, are often overlooked because investors place emphasis on large or small caps, investing experts say.
The stocks of mid-cap companies have less weight in information technology and health care, which are the two largest and widely followed sectors of the S&P 500, says Jodie Gunzberg, managing director and head of U.S. equities at S&P Dow Jones Indices.
“They are the investment equivalent of the ‘middle child syndrome,’ in which the first child is more prone to receiving privileges and responsibilities, while the youngest in the family is more likely to receive indulgences,” says Robert Johnson, a professor at the Heider College of Business at Nebraska’s Creighton University.
A distinct advantage of mid-cap stocks is these companies can be more diversified across sectors with much more in industrials and real estate, Gunzberg says.
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“The diversification can be attractive, but with industrials near the heaviest weight in the S&P MidCap 400, there may be less interest given the broader coverage of large caps where industrials have lower weight, she says.”
One drawback is that they are fewer portfolio managers who specialize in trading these stocks and less financial media and analyst coverage.
Mid Caps May Weather Rising Inflation
Compared to the S&P 500, the S&P MidCap 400 has returned an extra annualized 3.2 percent since 1991, when the index was launched.
The stocks of mid-cap companies have generally overcome the risks of small-cap companies, but still have “flexibility to grow before exhibiting growth deceleration seen in large caps,” Gunzberg says.
She adds one reason investors favor mid caps is because these companies usually have decent infrastructure, access to capital and developed distribution systems, but are “still nimble with motivated management teams to take advantage of opportunities quickly.”
Decelerating growth, a falling dollar and rising inflation are historically better for mid caps than small caps, Gunzberg says.
For every 1 percent rise in inflation, the sectors for inflation protection matter more. For instance, mid-caps outperformed small-caps on average only slightly, rising 3.2 percent compared with 3.1 percent, respectively, data show.
In the energy sector, the most important one for inflation protection, small caps offered a much higher inflation beta at 17 versus 13.9, she says. Higher inflation can hamper the return of stocks.
But mid caps do better historically with inflation than the small caps. That’s because the industrials are heavily weighted both in the S&P MidCap 400 and S&P SmallCap 600 and in the materials generates 50 percent of revenues overseas.
In the other sectors, the mid-cap industrials and materials rose 5.1 percent and 6.7 percent, respectively, during the 10-year period between January 2008 to December 2017. In comparison, small-cap industrials and materials rose 3.8 percent and 5.7 percent, respectively.
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Mid caps outperformed large-cap and small-cap stocks in both a flat and rising interest rate environment, Johnson says. Historically, when interest rates are flat, mid caps returned more than small and large caps. Conversely, when interest rates rise, mid caps return slightly more than its small cap and large cap counterparts. In a falling rate environment, mid caps returned less than small caps.
Johnson says, “It would appear that strictly from a return standpoint, investors would have preferred to have been in mid caps when interest rates were flat or rising and in small caps when interest rates were falling.”
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Why Investors Should Buy Mid-Cap Stocks originally appeared on usnews.com
