The Case for Midcap
Fade the “Magnificent 7”. Embrace the “Magnificent Midcap”
Key Points:
- While often overlooked, midcap stocks have delivered superior long-term returns and similar levels of volatility to large caps.
- Today, midcap stocks offer higher expected profit growth and lower valuations vs. large caps.
- Midcap significantly outperformed large cap following the bursting of the dot-com bubble, an environment with parallels to today.
Who isn’t tired of hearing about the “Magnificent 7,” the clever nickname for a select group of very large, technology-focused companies that have dominated investor attention and equity performance in recent years? But despite the new moniker, large companies capturing the lion’s share of investor attention is nothing new. It is telling that funds holding large company stocks have ten times the assets of those holding mid-sized companies! Investors would do well to pay more attention to oft-overlooked mid-sized companies (also known as midcap stocks).
What Does Midcap Mean?
Investment observers segment stocks by multiple factors, including by size (market capitalization or “cap”), with distinctions between large-, mid- and small-cap stocks. These size ranges do not stay constant, and the spectrum becomes larger over time as the stock market grows. For example, a $1 trillion market cap company, once unheard of, is now commonplace.
The most common benchmark of mid-sized companies is the Russell Midcap Index, which consists of the smallest 800 stocks in the Russell 1000 Index (an index of the 1,000 largest U.S. companies). This provides a fluid definition of what size constitutes a midcap company. As of August 2024, the index included companies with market capitalizations ranging from $1.5B to over $60B, with the majority in the $5B to $35B range (see Figure 1).
Figure 1: Percentage of Midcap Benchmark
Data Source: iShares Russell Midcap ETF as of 8/6/2024.
Mid-sized Companies, Big-Time Performance
While the biggest stocks may get the most attention, it is mid-sized companies that have historically delivered best for investors. Since the launch of the Russell Midcap Index in late 1991, midcap stocks have outperformed their large counterparts (as represented by the largest 200 stocks) by a whopping 625%! A comparison to the S&P 500 Index, the standard bearer for U.S. equities, looks strikingly similar. The benefit is even wider relative to the standard small company index, the Russell 2000 (see Figure 2 below). You could argue this history alone warrants a defined place in portfolios for midcap stocks. However, the setup today is even more attractive.
Figure 2: Growth of $1M (11/29/1991-7/31/2024)
Data Source: Bloomberg, BFM Estimates
Midcap Stocks Have Better Growth and Similar Stability, Yet Trade at a Discount to Large Cap
Regardless of size, most investors seek exposure to companies with the best combination of growth, low risk (using volatility as a proxy), and valuation. Large companies are perceived as less volatile, but this often comes at the cost of slower prospective growth due to more mature end markets. The expectation for smaller companies is higher growth, but with more risk as these companies tend to be less mature, have less stable balance sheets, and have more sensitivity to economic downturns.
This perception of a trade-off between growth and stability doesn’t fully match reality when it comes to midcap stocks. A careful review suggests faster profit growth and commensurate stability vs. large cap stocks (see Figure 3). Despite any preconceived notions, there is fundamental support for these outcomes. Mid-sized companies sit in the sweet spot of their corporate developmental lifecycle. They have matured enough to have established business models and strong competitive positions, while still being of a size where the growth runway is attractive.
Figure 3: Faster Growth with Similar Volatility/Risk
Data Source: Bloomberg, BFM Estimates
Even better, while historically midcap stocks trade at a premium valuation to their larger counterparts, midcap stocks currently trade at a 20% discount relative to large cap (Figure 4). Better growth and similar risk, at more attractive valuations, is a strong combination.
Figure 4: Lower Valuations
Data Source: Bloomberg
History Doesn’t Repeat, But it Does Rhyme
The stock market in 2024 has been characterized by a rabid enthusiasm for artificial intelligence. Early inroads in this new technology have mostly accrued to the largest companies, as have the stock market gains. Over the last two years, the Midcap Index has trailed the S&P 500 Index (consisting of larger companies) by one of the widest two-year margins on record, second only to the strong market of the late 1990s. Comparisons to that period do not stop there. Like AI today, gains in the late 20th century were fueled by excitement over the internet, driving valuations for large cap stocks to all-time highs. Also at that time, midcap stocks traded at an unusual discount to large caps, just like today. The late ‘90s market performance was also concentrated in a small number of companies, setting then-records for index concentration. Today, the S&P 500 has eclipsed those records, with 35% of the index constituted by just the top 2% of companies. This exposes investors to elevated risk should that small group falter.
If history is a guide, the future for mid-sized companies is bright. Eventually, excitement over the internet and heady stock valuations became too much to bear. That combination set off a remarkable period of relative outperformance for midcap stocks, with the Russell Midcap Index outperforming the S&P 500 for six straight calendar years. The midcap index returned +8.4% per year between 2000 and 2005 compared to -1.1% for the S&P 500! In fact, large cap stocks failed to make a new high for almost seven years.
Figure 5: Growth of $1M (12/31/1999-12/31/2005)
Data Source: Bloomberg
Bottom Line
BFM has long been an advocate for holding a strategic allocation to mid-sized companies given their fundamental benefits, and the current environment continues to reinforce this belief. It is easy to look at the recent performance of large cap stocks and presume the current environment will continue indefinitely. But with the benefit of historical context and a longer-term view, investors are well-served to position their portfolios differently than the herd by holding not just the largest companies but also maintaining, or even increasing, their allocation to the magnificent midcap.
Market Commentary Disclaimer
This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.
Professional Designation Minimum Requirements Disclosure
CFA® – Chartered Financial Analyst. Minimum requirements for the CFA® designation include an undergraduate degree and four years of professional experience involving investment decision-making, in addition to successful completion of each of the three CFA level examinations.