Why Mid Caps Are Still Marvelous

Mid-cap stocks are, well, stuck in the middle this year. The S&P MidCap 400 Index is lagging the large-cap S&P 500, but the mid-cap gauge is beating the small-cap Russell 2000 by nearly 600 basis points.

Mid caps' 2021 laggard status, at least relative to large caps, shouldn't be alarming because as experienced advisors well know, stocks in the middle have long track records of besting large caps. Mid caps also have frequently, and for long stretches, beaten small caps while doing so with noticeably less volatility.

Alone the mid- vs. small-cap comparison is something for advisors to not only ponder, but also discuss with clients. Many clients are already aware of the return potential of small caps, but fewer are aware o of that same, if not superior, potential with mid caps. Additionally, while small caps have long histories beating bigger peers, that effect is waning and has been for some time – perhaps far longer than many advisors realizes.
“Though small-cap performance is enticing over the 90 years since 1926, the excess returns were mostly generated before 1981, when Rolf W. Banz published his seminal paper on small-cap stocks,” says Nicolas Rabner of FactorResearch. “Since then, small-cap performance has been rather lackluster, so there is far less enthusiasm for the size factor among investors today than in the past.”

Mid Caps Have an Impressive Run Going

Getting back to mid caps, it's worth noting this segment is on an enviable run of its own that's lasted for the bulk of the 21st century to date.

“Mid-cap stocks have had a great century—delivering roughly double the return of large caps, century-to-date. Large caps have largely outshined them over the last decade, though, driving down the relative valuation of both mid- and small-cap stocks,” says Simeon Hyman, ProShares Global Investment Strategist.

Several fundamental factors confirm the utility of embracing mid-cap equities today. For example, on the basis of price-to-book, mid caps are cheaper than the S&P 500 and when it comes to net debt against earnings and return on assets (ROA), mid caps are vastly superior to their smaller counterparts. That ROA advantage is meaningful, as Hyman points out.

“Higher ROA gives mid-cap stocks a potentially superior cushion if inflation pressures, margins and lower leverage limit their exposure to higher interest rates,” he notes. “We’ll leave the debate over the relative attractiveness of large- versus mid-cap stocks for another day, but for those prudently seeking options outside of the large-cap space, mid-cap stocks shouldn’t be overlooked.”

More Reasons to Like Mid Caps

Advisors have other points of emphasis to bring up with clients regarding mid-cap stocks. One of those points is particularly relevant today: Mid caps often perform admirably when interest rates rise, which seems like a foregone conclusion amid low Treasury yields and rampant government spending.

On that note, the S&P MidCap 400 has a 15% weight to financial services stocks, a fair amount of which are credible takeover targets as banks turn to consolidation due to slack loan growth.

Additionally, traditional mid-cap indexes are usually cyclical in nature, levering those benchmarks to economic recovery. For its part, the S&P MidCap 400 devotes about a third of its weight to industrial and consumer discretionary stocks.

Put it all together, and mid caps are the ideal equity segment in which advisors can add value for clients. They're likely overlooking mid caps on their own and could be pleasantly surprised by the positive outcomes that come with this asset class.

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