Exciting small companies receive their fair share of attention from investors, even if their stocks have short track records. Less-glamorous but more predictable large company stocks with greater stability also get noticed. But sandwiched in the middle of these are a huge swath of medium-sized companies.
Investors who ignore these in-betweeners or get them only through indexes may be selling them short says Don Wordell, who manages the $3.8 billion RidgeWorth Mid-Cap Value Equity Fund. According to Wordell, the beauty of mid-caps is that they offer the same opportunity to exploit market inefficiencies that small-cap stocks do, yet mid-caps also have the kind of liquidity large companies do. “They combine the investment characteristics of both,” he says.
Because mid-cap companies have already been small caps at some point in their lives, Wordell contends that they have tested business models and experienced management. They’re especially well-suited for an economic recovery because they often have higher earnings growth than small caps and greater expansion potential than their more mature large counterparts. And mid-caps can be swallowed up by larger companies with swollen stock values seeking to complement core competencies or reach new markets.
Mid-caps have also done well against other stocks over recent short and longer-term periods. Over the five years ended March 31, mid-caps gained 212%, while large caps gained 169% and small caps 197%. Led by the numerous real estate investment trusts (REITs) and utilities in the mid-cap space, the Russell Mid-Cap Index posted a 4% gain during the first quarter of this year as bond yields moved lower and investors sought high-yielding safe havens. The large-cap Russell 1000 gained 2%, while the small-cap Russell 2000 rose 1% over the same period.
Mid-caps can also can make sense as a longer-term portfolio diversifier, according to a study from RidgeWorth last year noting that mid-cap stocks have delivered higher returns than large- and small-cap stocks for most rolling periods during the past 33 years. While mid-caps have participated in most of the market’s upside, they have also avoided much of the downside of small caps. Historically, the standard deviation of mid-caps has been closer to that of large companies than that of smaller ones.
The study also suggests that the stocks offer a way to balance market risk with appreciation potential, a characteristic that’s particularly attractive when markets appear to be at an inflection point. If the economy continues to gain momentum, mid-caps could outperform large caps. But if it falters, or if economic indicators begin to languish again, mid-caps would likely have better downside protection than more speculative small company stocks.
Nonetheless, Morningstar analyst Michael Rawson believes that the diversification benefits of mid-caps may not be all that great. In a report from late March of this year he wrote, “U.S. mid-caps have historically provided only minor diversification benefits. Over the past decade, the Morningstar Mid Cap index was 0.96 correlated with the S&P 500 index. Mid-caps also behaved similarly to U.S. small-cap equities during that time, exhibiting a correlation of 0.98 with the Morningstar Small Cap Index.” He added that the recent spurt in mid-cap stocks “has caused them to look expensive relative to large-cap stocks,” and that their dividend yields, on average, are less than large caps’. Many investors may furthermore already have ample exposure to mid-caps through broader market indexes.
Wordell says investors have warmed to mid-cap stocks, which means they aren’t as cheap as they were a few years ago, but adds there are still plenty of bargains for those who look beyond territory that has been too picked over.
“Valuations for REITs and utilities are certainly stretched by a number of measures,” he says. “But we are still finding lots of opportunities elsewhere.” Because they are often underappreciated and overlooked by analysts, mid-caps have fewer investors chasing them than large caps, which Wordell says makes it easier to uncover companies trading at levels below where he thinks they should.
Wordell looks for investment opportunities among stocks selling at below their historical valuation levels, using measures such as price-to-earnings ratios or price-to-book values. He also prefers companies that pay dividends, whether or not the payouts are particularly high. “Dividends aren’t a panacea, but stocks of companies that pay them are typically less volatile. And they’re a message to the marketplace about the financial discipline of a company.”
If a company passes those screens, he will try to determine whether there is a fundamental catalyst that could drive the stock higher in the next 12 to 24 months. Often he does that by talking to management, competitors and suppliers. The firm’s Orlando, Fla., location is a distinct advantage in that regard. “A lot of people associate Orlando with theme parks,” he says. “But there are also a lot of conventions that pass through here, and that provides plenty of opportunity for us to connect with people we need to speak to.”
The companies in the portfolio typically have a market capitalization from $1 billion to $25 billion, and they have a weighted average market cap of $13 billion. While his intention is to hang on to stocks for a year or two, his strict sell discipline might hasten a company’s exit from the portfolio. “It takes three criteria—valuation, dividends and fundamentals—for a stock to get into the portfolio. But it only takes violating one of them for it to be removed.”
Favoring Cyclical Stocks
Wordell believes the recent popularity that mid-cap REITs and utilities have enjoyed is likely to be short-lived. The winter weather boosted business for utilities, but it has passed, making their future earnings more uncertain. And the falling interest rates that helped both sectors aren’t a sure thing. “Interest rates are likely to move higher over the next year or two, so it’s likely that utilities and REITs will underperform going forward,” he says.
The U.S.’s annual GDP growth, he believes, will average a relatively healthy 2.5% to 3%. With that in mind, he is adding to positions in cyclical sectors that stand to benefit from an expanding economy, including industrials, energy and health care. In that last sector, he finds managed care providers particularly attractive.
“Today, there is an acceleration of the trend toward people paying a larger share of health-care costs through higher deductibles and other cost-sharing measures. That puts more emphasis on cost control.” Also, the growth in the aging population over the next decade, along with more people seeking health care because of the Affordable Care Act, will increase demand for services.
Valuations are also attractive among certain members of the group, such as fund holding Cigna, which trades at a modest 10 times 2015 earnings. The stock pays a modest dividend that Wordell believes could increase over time as management makes strategic moves such as selling non-core businesses and buying back stock with the company’s excess cash flow. Another health-care name, Omnicare, distributes drugs to skilled nursing facilities. With many drugs going off patent in 2015, the company should benefit from lower costs. The stock trades at 14 times earnings and has a dividend yield of 1.4%.
In the industrials sector, fund holding and industrial automation powerhouse Rockwell Automation should deliver earnings “well above what Wall Street expects” as automakers expand facilities in the U.S. and Asia to accommodate increasing demand. Waste management company Republic Services’ business will accelerate as commercial construction and other areas of the economy expand.
Another potential beneficiary of the expanding economy is home builder M.D.C. Holdings, which specializes in single-family homes. With household formation accelerating, Wordell believes the company should see strong growth in the next year or two. M.D.C. is one of the smaller stocks in the portfolio, with a market capitalization of just $1.35 billion. It trades at a modest 1.1 times book value and has an attractive 3.6% dividend yield.
Energy holdings include offshore supply vessel manufacturer Tidewater, which has a 2% dividend yield and a $2.5 billion market capitalization. Stored supplies of gas are down 50% from last year because of the unusually high spike in demand last winter. Wordell believes that with constrained supplies, gas companies will be doing more drilling, creating increased demand for Tidewater’s young fleet of vessels.
With global mergers and acquisitions accelerating, boutique investment bank and investment management firm Lazard is seeing a growth in that area of business, where it provides advisory services. The stock has a 2.7% dividend yield and a $6 billion market capitalization. “Large companies that can’t grow organically are turning to acquiring midsized companies for growth,” says Wordell. “That’s good news for Lazard and for the fund.”