Mid-cap stocks could generate more growth in 2021 as the economy rebounds from the global pandemic and benefits from both a falling U.S. dollar and inflation.
Midcaps likely have not gotten the attention they deserve as “tech titan large caps have been the darlings of the stay-at-home era, and small caps have recently benefited from reopening prospects,” says Mike Loewengart, managing director of investment strategy at E-Trade Financial, an Arlington, Virginia-based brokerage company.
Investors could find overlooked opportunities in midcaps, and they should not be lumped in with small-cap stocks, he says.
Mid-cap stocks could benefit from better earnings when the economy recovers, says Jodie Gunzberg, managing director, chief institutional investment strategist at Morgan Stanley Wealth Management.
“As markets move toward employing an early cycle playbook, midcaps may benefit, especially those with exposure to procyclical industries and more aggressive growth opportunities that can take advantage from recovery tailwinds,” she says.
The S&P MidCap 400 Index on average has outperformed in the 12 months following the troughs of large caps during past recessions — midcaps returned 51.3% compared to large caps returning 29.4%. The strong mid-cap outperformance holds for 24-month periods with large caps returning 48.2% compared to 80.3% for midcaps, Gunzberg says.
The S&P updated its valuations of large-, medium- and small-cap companies on Dec. 8, raising them to $9.8 billion in market capitalization or more for the S&P 500, $3.2 billion to $9.8 billion for the S&P MidCap 400 and $700 million to $3.2 billion for the S&P SmallCap 600.
In 2020, the mid-cap sector has trailed the S&P 500, which includes the largest tech stocks. The total return year to date through Dec. 15 of the S&P 500 is 16.4%, while the S&P MidCap 400 is 12.6%, followed by the S&P SmallCap 600’s return of 10.5%. The Russell 2000, a small-cap index, generated 19%, followed by a return of 15.8% for the Russell Midcap and 18.9% for the Russell 1000.
As a new year approaches, investors who are interested in mid-cap stocks should keep a few points in mind:
— Factors that could boost midcaps.
— Mid-cap companies add diversification.
— How to invest in mid-cap stocks.
Factors That Could Boost Midcaps
The falling U.S. dollar, inflation, growth and moderately rising interest rates could all be beneficial for midcaps, Gunzberg says. For every 1% decline of the U.S. dollar on average, the S&P MidCap 400 rose 1.9% compared to a 1.5% rise in the S&P 500, according to monthly data from April 1998 to 2019.
“Though large caps generate more revenues from overseas, midcaps are able to benefit more from international revenues growth from business expansion as the U.S. dollar falls,” she says.
Inflation also helps midcaps more than large caps with an inflation beta, a measure of volatility, of 3.1, double that of the 1.5 measure for the S&P 500. This means that the same inflation hedge is historically achieved with half the allocation to midcaps than to large caps, she says.
“Given the inflationary pressures today, not just from the stimulus but from the demographic shift and deglobalization, midcaps may play an important portfolio role,” Gunzberg says. “Moderate increases in interest rates have led midcaps to an average monthly outperformance over large caps of 16 basis points over a 10-year period ending 2019.”
While large-cap stocks have outperformed, a “change in style leadership could be unfolding,” she says.
Since the start of 2014, large-cap indices outperformed by 59.6%, and on a relative basis, small- and mid-cap stocks priced in more fundamental risk than large-cap peers, Gunzberg says.
“Smaller stocks have tended to outperform early in an economic and market cycle. As the U.S. potentially moves from recession to recovery in the second half of 2020, (the) macro backdrop could favor small-mid capitalization exposure,” she says. “Smaller companies tend to be more domestically oriented than large-cap companies, and with about 80% of small-mid capitalization revenue coming from the U.S., these stocks may benefit more from U.S. fiscal stimulus.”
Midcaps tend to take off during economic expansion and can help protect investors from inflation, Loewengart says. Sometimes they were former small-cap companies that have realized their growth potential and could be a stepping stone to being a large-cap stock.
“Historically, midcaps have been less volatile than small caps, and with typically domestic-focused operations, they can also provide some insulation from geopolitical and trade-related issues,” he says.
Mid-cap stocks from 1966 through 2018 performed differently during various monetary policy conditions. When the Federal Reserve pursues an expansive monetary policy or when interest rates were falling, midcaps returned 22.9% annually from 1966 through 2018, says Robert Johnson, a finance professor at Creighton University’s Heider College of Business in Omaha, Nebraska. When the Fed was pursuing an indeterminate monetary policy when rates were neither rising nor falling, midcaps returned 12.4%. When the Fed was pursuing a restrictive monetary policy or when rates were rising, midcaps returned 5.5%.
Mid-Cap Companies Add Diversification
Mid-cap stocks are solid diversifiers with “relatively attractive” valuations compared with large caps, Gunzberg says. They have a favorable exposure to cyclical sectors like industrials, housing, transports and consumer discretionary, which are all likely to benefit from a potential V-shaped recovery, she says.
“Beyond the recession recovery trade, we also see midcaps benefiting longer term from post-COVID-19 virus structural trends — those trends related to increased investments in health care and infrastructure as well as deglobalization and re-onshoring of supply chains, Gunzberg says.
Mid-cap indices can provide broad exposure in passively managed strategies such as exchange-traded funds that invest in benchmarks, help diversify portfolios and mitigate potential concentration risk with large-cap exposures, she says.
Mid-cap growth stocks are not a good diversifier to the S&P 500 given the relatively same sector weights, but mid-cap value stocks are, says Michael Underhill, chief investment officer of Capital Innovations in Pewaukee, Wisconsin. Mid-cap value stocks rose by 3.8% compared to mid-cap growth stocks that returned 33.4% as of Dec. 15.
“A high interest rate environment, steepening yield curve, higher inflation and an improving economy would benefit mid-cap value stocks more,” he says. “These are prospective factors looking out into 2021, and that is why mid-cap value is better positioned for 2021.”
How to Invest In Mid-Cap Stocks
Adding mid-cap stocks to a portfolio can provide investors with an added layer of diversification. The easiest way to capture the mid-cap market is through funds such as the Vanguard Mid-Cap ETF (ticker: VO), Loewengart says.
VO is a good choice for investors purely seeking exposure to the mid-cap sector since the fund employs an indexing investment approach designed to track the performance of the CRSP U.S. Mid Cap Index, a broadly diversified index of stocks of midsize U.S. companies, Johnson says. The fund is rated five stars by Morningstar, a Chicago-based research investment firm, has a miniscule expense ratio of 0.04% and a year-to-date return of 17.2%, a one-year return of 18% and a three-year return of 12%.
Midcaps provide a strong combination of earnings growth potential and stability aided by income generation, says Todd Rosenbluth, head of ETF and mutual fund research at CFRA, a New York-based financial research company. Compared to small caps, they tend to have better “risk profiles and can withstand market volatility,” he says.
In 2020, the iShares Core S&P Mid-Cap ETF ( IJH) outperformed the iShares Core S&P Small-Cap ETF ( IJR), even though it lagged the iShares Core S&P 500 ETF ( IVV). IJH generated a total return of 12.4% as of Dec. 21, while IJR returned 9.7% and IVV gained 16.4%.
For investors that want exposure to midcaps with an income component, the ProShares S&P MidCap 400 Dividend Aristocrats ETF ( REGL) is a good alternative as it holds only companies that have raised dividends for 15 consecutive years, he says.
The John Hancock Multifactor Mid Cap ETF ( JHMM) owns companies with strong profitability and attractive value traits like Cadence Design Systems ( CDNS) and Skyworks Solutions ( SWKS), Rosenbluth says.
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