Mid-cap stocks are expected to perform well during the economic expansion, but some managers are looking for opportunities in larger growth companies. Part of their reasoning is that mid-cap stocks held up remarkably well during the 2000-2002 bear market and sport richer valuations than many of their larger rivals.
"Mid-cap stocks are the fund's center of gravity, but we own small- and large-company stocks if the valuations are attractive," says Chip Tucker, co-manager of Selected Special Shares. Mid-cap stocks still have legs, he believes, but there are values in larger companies with long-term growth potential.
Some money managers do not expect mid-cap stock returns to be as high as they have been over the past few years. The average mid-cap stock fund gained 16% over the year ending in August.
David Wallack, manager of the T. Rowe Price Mid-Cap Value Fund, is less sanguine about medium-size companies even though margins, cash flow and balance sheets are strong. "Having now outperformed large-cap stocks for several years, the valuations of medium-sized companies are, on average, no longer compellingly low relative to their larger peers," he says. "We continue to find good risk-reward candidates among mid-caps, but they are harder to come by than in previous years."
Wallack is investing in companies that are out of favor but show some type of catalyst for change. The fund's average holding is growing earnings at 12% annually. Mid-cap stocks typically offer greater return potential than larger established firms and are less risky than small companies. He says that by investing in unpopular stocks, his fund should be less volatile than one investing in growth stocks. And once the fund's beaten-up pickings regain favor, the fund should profit.
That philosophy has put Wallack into stocks like SAFECO, which had financial problems a few years ago. New management sold off some unprofitable business lines and improved profitability.
Wallack has 70% of the fund's assets invested in the financial, consumer, technology, business services and health care industries. Other ugly ducklings the fund owns include St. Paul Companies, Diamond Offshore Drilling and Genworth Financial.
Because there are slim pickings in most mid-caps, some managers are investing in well-seasoned medium sized firms. Hugh Denison, co-manager of the Heartland Select Value Fund, now buys larger mid-cap stocks that pay dividends. The average holding of the fund sports a capitalization rate of $3 billion.
"We like the larger names," he says. "We are focusing on dividend payers. Dividend-paying stocks are outperforming nondividend paying stocks and represent better values."
Denison expects the market to rotate to larger companies. "We have a list of stocks we would like to buy," he says. "Larger companies that were considered growth stocks are now value stocks. We are not lacking in ideas to look at."
Denison holds just 40 stocks. He recently purchased larger mid-cap names like Wisconsin Energy. The reason: The market has frowned on utility stocks. Nevertheless, the stock represents good value and yields 3%.
NRG Energy generates electric power and sells it in the Northeast. The company is coming out of bankruptcy, but its financials look good, and its product does not face stiff competition.
Meanwhile, Bill D'Alonzo, CEO of the Brandywine Fund, says he is still finding strong earnings growth in the mid-cap sector. The fund's average holding is growing earnings at 50%. The fund owns New York Stock Exchange-listed companies like Deere & Co., Manpower Inc., Southwestern Energy and The Timken Co. All three trade at price-to-earnings multiples that are about 30% of their growth rates.
Brandywine's strategy of buying rapidly growing companies that are likely to exceed consensus earnings estimates has put it into stocks primarily in the information and service sectors of the economy over the past few years. But as the economic recovery gained strength this year, the fund purchased more capital goods and energy companies.
"Given encouraging earnings trends, more reasonable price-to-earnings ratios and the maturing economic recovery, we would not be surprised to see mid-sized and larger growth company stocks show some renewed signs of life."
Nevertheless, D'Alonzo stresses that there is no free lunch in today's economy. The wild cards are energy prices and interest rates. "The oil price situation needs to enter any discussion about the near-term economic outlook," he says. "We're being very conscious of oil prices in our research, to recognize related challenges and opportunities created on the individual company level."
Despite the strong performance of mid-cap stocks over the past few years, financial advisors can use a combination of large-and small-company growth and value funds. They can forego investing in mid-cap funds without hurting their clients' risk-adjusted rates of return. For example, mid-cap value stocks, growth and blend funds performed halfway between their large-stock and small-stock fund peers, according to Morningstar Inc., Chicago.
Past research by Dimension Fund Advisors, a Santa Monica, Calif.-based institutional fund group, studied 23 three-year periods from 1928 through 1996. The research reveals that the best-performing stocks or worst-performing stocks either were in the top 10% of the largest stocks or the top 10% of the smallest stocks traded on the stock exchanges. In only three three-year periods since 1928 did mid-sized stocks either rank as the best or worst performing stocks.
On the mutual fund side, research by the No-Load Investor, Orinda, Calif., found that mid-cap stock funds had the same performance as an equal mix of large-company stock funds and small-company stock funds from 1949 through 1998. Both groups returned 15.8% annually. The reason: Mid-cap stocks have had a high correlation to an evenly split large-company and small-company mix.
Morningstar's data show that most mid-cap stock funds own both large-cap and mid-cap stocks. For example, the average mid-cap blend fund has 26% of assets in large-company stocks. Mid-cap value funds, on average, have 32% of assets in large-company stocks. And mid-cap growth funds have 23% of assets in large-cap stocks.
The Artisan Mid-Cap Fund is an example of a fund that has a large stake in big companies-40% of the fund's assets are invested in large-cap stocks. The average market capitalization of the stocks owned by the fund is $6.5 billion, the largest in the fund's history, according to Morningstar.
Morningstar Analyst Paul Herbert says that due to cash inflows from open channels, the fund manager has increased the number of holdings and the market capitalization of the fund's stocks. With many large-company growth stocks selling at attractive valuations, the fund should continue to perform well when large-cap names lead the market. The fund's largest holdings include Thermo Electron, Invitrogen, Yahoo! Inc., Danaher Corp. and CIT Group.     
Tucker's Selected Special Shares is another mid-cap fund that will invest a sizable portion of assets in large companies. He says the fund has outperformed the broad market due to flexibility in owning large, medium and small stocks selling at reasonable prices in relation to long-term growth. Over the five years ending in August, the fund has outperformed the Wilshire 5000 by 3.3% in annual return. The fund uses the best picks of eight analysts who cover different industries.
Recent purchases include AutoZone, which is selling at just 11 times forward earnings but has a history of growing earnings at double-digit rates, and Sigma- Aldrich, a manufacturer of research chemicals with earnings growing at more than 10% despite a weak stock price. The company profit margins are on the rise due to product price increases.
Other money managers stress that most funds classified as mid-cap own too many large names. As a result, the funds do not optimize well with other types of funds based on investment style.
Carl Marker, manager of the IMS Capital Value, a mid-cap blend fund, is convinced that there is too much style drift in the majority of mid-cap stock funds. Marker prefers to stick with mid-cap issues. He has minor style drift due to capital appreciation or depreciation in stock prices, which he says is due to his stock picking methods. Marker identifies stocks based on fundamentals.
But he won't buy a stock unless it shows price and earnings momentum. Today, he has just 9% of assets in larger-cap stocks due to capital appreciation. But he will not sell the stocks unless their earnings momentum slows.
Currently, his fund is concentrated in the technology, health care, consumer staples and financial services sectors. For example, he likes E*Trade. The online brokerage firm's earnings were up 80% last year, but the stock sells at just 18 times earnings.
He also likes Service Corp., which owns cemeteries nationwide. The company's stock dropped from a high of $50 to $6. But sales and earnings are growing at 12%. "Mid-cap stocks are the place to be," he says. "They have outperformed large- and small-cap stocks based on risk and return over the past 20 years. They have historically been a neglected asset class. Mid-cap stocks tend to get purchased by deep-pocketed, large-cap buyers. There are greater opportunities to uncover under-recognized assets."