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."