It's High Time to Finally Embrace Mid Caps

These days, it's easy to be fond of smaller stocks. What with all the talk of cyclicals coming back into style and the reflation trade.

Of course, there's a difference between mid- and small-cap fare. By the strict definition, a mid cap is a stock with a market capitalization of $2 billion to $10 billion, but plenty funds – passive index and exchange traded funds as well as actively managed funds – drift into the $15 billion-plus area.

Advisors, likely more so than many of their clients know two truths about mid-cap stocks. First, the asset class is often referred to as the market's sweet spot. Second, despite that sweetness, the asset is grossly overlooked relative to both large and small caps.

“Mid-cap companies are usually not as dependent on a single product as their smaller-cap peers can be, meaning that mid-caps' revenue and cash flow are often more consistent and the stock price is less volatile,” notes Morningstar. “But mid-caps are also not yet hampered by their size, either (meaning that once a company reaches the mature large- or giant-cap stage, its growth potential slows down).”

Those are compelling traits and they speak to the second point above regarding client portfolios often being inadequately exposed to mid caps. A basic total market index fund, say the Vanguard Total Market ETF (NYSEARCA:VTI), is likely to feature an 18% to 20% allocation to mid caps evenly divided among the Morningstar style boxes of core, growth and value. However, that may not be enough, particularly for younger clients or those looking to diversify away from large caps without incurring the volatility associated with small caps.

Mid-Cap Track Record too Good to Ignore

Advisors know that past performance isn't a guarantee of future returns, but they also know that while history doesn't always repeat, it often rhymes.

That's one way of saying advisors have facts on their side when discussing mid caps with clients and the facts are, well, the facts meaning they are applicable to young FAANG-crazy client as well as the consumer staples/utilities-heavy older client.

“When we analyzed absolute returns on a five-year rolling basis since 1994 according to a monthly frequency, mid caps outperformed large caps 72% of the time and small caps 93% of the time, as shown below,” according to State Street research published in January. “Moreover, Sharpe ratios were higher in 62% and 100% of the 257 five-year rolling periods analyzed versus large caps and small caps, respectively.”

Another avenue for advisors to add value vis a vis the mid-cap conversation is on the subject of volatility. Many clients are programmed to believe large/mega caps are the least volatile stocks. Alas, that's not necessarily true.

“While the Sharpe ratio considers all volatility—both good and bad—the Sortino ratio only considers the standard deviation of the downside movements,” notes State Street. “Mid caps had higher Sortino ratios 60% and 100% of the time versus large caps and small caps, respectively.”

Another Value Add

Another way for advisors to bring value to table in the mid-cap conversation is to discuss value. These days, there's not much value in basic mid-cap benchmarks. The Russell Midcap Index sported a price-to-earnings ratio of nearly 43x at the end of January while its “value” counterpart was at 37x earnings.

The WisdomTree U.S. MidCap Fund (EZM) resided at just 17x earnings as of Jan. 31, a modest premium relative to its long-term average of 15.4x.

Another benefit of this particular is that it's actually a rather pure mid-cap fund in a world where that designation is increasingly difficult to come by.

“While equity markets have rallied to new highs from the throes of the pandemic, the Russell Midcap Index has started to look like a mid-cap Index in name only,” according to WisdomTree. “As of January 31, the percentage of companies WisdomTree classifies as mid-cap (with market capitalizations between $2 and $10 billion) has steadily fallen to about 24% of the Index. Meanwhile, large-cap companies (with market caps more than $10 billion) make up the remaining 76%.”

Said another way, if an advisor is going to talk mid caps with clients, it's probably best to actually steer them to a true mid-cap product so they derive the most benefit from this asset class.

Related: Good News Advisors: Dividends Are in Again