While the market favors the big boys, smaller stocks
keep chugging along.
The performance of mid-cap stock funds, which invest
in companies with market capitalizations of $1 billion to $10 billion,
slowed in 2006 after registering stellar gains in 2004 and 2005.
One reason for the underperformance: Mid-cap growth stocks retrenched due to concerns about rising inflation and slowing economic growth. There was a broad sell-off in mid-cap stocks during the first half of 2006 that drove investors out of growth and into mid-cap value stocks.
"A sharp sell-off in speculative stocks, including overseas names in the emerging markets, sparked a broad correction in the United States," Morningstar analyst Kerry O'Boyle says in a recent report. "While the more aggressive strategies suffered, value-oriented styles again offer more stability."
Current trends would appear to favor large-cap stocks for a couple of reasons: Small-cap and mid-cap stocks performed well during the beginning of the economic cycle, but investors were rotating into large-cap stocks-a common trend later in the cycle. Large companies, with more cash reserves and diversified businesses, should perform well if the economy slows or revives.
Nevertheless, money managers say mid-cap stocks will see inflows when investors unload smaller-cap stocks. "You are seeing a shift to large-cap stocks and risk aversion as the economy calms down," says Thomas McDowell, manager of the AIC Rice Hall James Mid-Cap Portfolio. "But a lot of investors in small- and micro-cap stocks are looking to mid-cap stocks as a way to find reasonable growth with not as much risk as small caps."
McDowell says that he invests in smaller mid-cap stocks with average market capitalizations of $4 billion. By contrast, the average market capitalization of the Russell 2000 Mid-Cap Index was about $7 billion. He has been buying stocks such as Weight Watchers, a diet company; Covanta Holdings, which runs waste energy plants; and Alliance Data Systems, which services credit cards and reward cards. All three companies' price-to-earnings ratios were below their 20%-plus earnings growth rates.
Although many analysts expect large-cap stocks to outperform mid-cap stocks, mid-cap stocks have legs, based on financial research. A working paper, Persistence in Style-Adjusted Mutual Fund Returns, by Sung-Jun Woo, an economics professor at Harvard University, found that differences in style-adjusted fund returns persist for up to six years. Neither one-year share price momentum, expense ratios, book-to-market values of fund holdings, loads or the level of net assets have an impact on the persistency of performance.
Other research shows that regardless of investment style, fund managers who performed well over the long term continue to rack up solid gains. Russ Wermers, University of Maryland finance professor, and Halbert White Jr., University of California finance professor, show that fund managers with good long-term track records exhibit persistently superior alpha values on their portfolios. Alpha is a measure of how a portfolio performs in comparison to the risk-free rate of return on U.S. Treasury bills.
The results of this research were validated by the stock market performance at year-end 2006. Smaller-cap stocks rallied late in the year, following a mid-year sell-off. The Russell 2000 Mid-Cap Index hit record levels in the fourth quarter, and over the past year outperformed the S&P 500 and Dow Jones Industrial Average as of the end of November 2006.
Although market sentiment favored large-cap stocks, mid-cap stocks were expected to benefit from a broad market rally. On the economic side, declining energy prices and steady interest rates were expected to benefit smaller companies. In addition, an increase in mergers and acquisitions was boosting share prices. For example, the shares of FoxHollow Technologies benefited from Merck's minority stake in the company. And the proposed acquisition of Harrah Entertainment by private equity firms could be a harbinger of things to come in the mid-cap market.
'Money managers characterize the mid-cap sector as a "stock picker's market," not a play on an asset class. "Our multiples of mid-cap companies are unusually low right now," says Robert Lanphier, co-manager of the William Blair Mid-Cap Growth Fund. "Half of our portfolio is trading in the bottom quartile of historic five-year ranges. Multiples have compressed because earnings are strong and stock prices haven't kept up."
Lanphier says that high-quality growth companies with strong balance sheets and market share should perform well. Even if the market rotates into large companies, mid-cap growth stocks should get pulled along for the ride.
This year's earnings on his average holding are expected to be more than 20%. Meanwhile, the average stock earnings of the Russell Mid-Cap 2000 Index are projected to grow at 16%. The debt-to-total capital of his holdings is half of the benchmark index. And the return on equity of his holdings averages 22.5%, compared to 20.8% on the benchmark.
Lanphier says that going into 2007, he had cut back slightly in consumer and industrial stocks. But he is sticking close to the sector weights of the Russell Mid-Cap Index. Companies he favors included Car Max, which exhibited strong same-store sales growth and accelerating earnings. The company was trading at 18 times earnings while earnings were growing at 25% annually; Fastenal, which makes nuts and bolts; Paychex; and Iron Mountain data storage companies. Projected earnings and return on equity of the last two companies were higher than the benchmark.
On the value side, Christopher Davis, co-manager of Selected Special Shares, agrees that it is a stock picker's market for mid-cap stocks. He focuses on companies selling at reasonable prices based on the long-term growth of their businesses. The fund's average holding sports a price-to-earnings ratio of 19.7, while earnings are growing at 23% annually.
He has large positions in Garmin, which designs and manufactures devices for global positioning systems; First Marblehead Corp., a financial services company that originates and securitizes student loans; and Hunter Douglas, a manufacturer of window blinds and architectural products.
Going forward, Davis says the stock market should be driven by business fundamentals. There could be short-term declines in stock prices of businesses that have longer-term growth potential, such as Expedia. But declines are buying opportunities. In addition, many stocks of well-run companies are trading at a discount or a little premium to the average public company.
Wallace Weitz, manager of the Weitz Hickory Fund, is also buying on weakness, particularly in the financial services and media industries. He is taking a contrarian approach to mid-cap stocks. The companies must have a strong niche or franchise, as well as strong balance sheets and cash flow.
"Our stocks were getting cheaper, setting up portfolios for future gains," he says. "The portfolio positions have paid off. We still expect credit and liquidity problems to affect individuals, hedge funds and financial institutions to a degree [in 2007] ... The economy is very resilient and we're not expecting a disaster. Nevertheless, it seems the fear and volatility makes life interesting for investors."
The fund, which owns just 30 stocks, is invested in consumer products, mortgage services, media, insurance and health care. Largest holdings include Redwood Trust, Countrywide Financial, Cabela's and Coinstar.
On the mid-cap growth side, Christopher McHugh, manager of the Turner Mid-Cap Growth Fund, is optimistic. Growth stocks had underperformed value stocks for more than five years, corporate earnings were solid and the market was expected to rotate into growth.
The stocks of the Russell Mid-Cap Growth Index are trading at 21 times earnings, while earnings are expected to grow 16%. Meanwhile, his holdings are growing at 24% annually, while the price-to-earnings ratio of the stocks was 18.
McHugh doesn't expect inflation or rising interest rates to be a problem unless the price of oil surges to all-time highs again. That would have a large impact on consumer spending. "A slower economy favors growth stocks because investors are paying for earnings growth," McHugh says. "There is a lot of business confidence because of all the mergers and acquisitions and private equity bids for companies."