By Coulter Regal, CFA, Product Manager
In the vast landscape of investment opportunities, mid-cap stocks often find themselves overshadowed by their larger and smaller counterparts. Large-cap stocks, with their stability and market dominance, tend to steal the limelight, while small-cap stocks offer potential for rapid growth but come with higher risk. However, mid-caps may be an overlooked sweet spot in the market, offering an attractive mix of characteristics from both larger and smaller stocks. Current multi-decade low valuations are further driving allure for mid-caps.
Where Growth Potential Meets Stability
Mid-cap stocks represent a unique segment in the U.S. equity market, striking a balance between potential for business growth and relative stability. Differing from small-cap stocks, mid-cap companies have typically advanced beyond their most unpredictable growth phases. But unlike many larger companies, they still possess greater potential for expansion and scalability. This unique positioning allows mid-caps to offer a distinct risk/return profile, which is particularly noticeable when compared to the overall underperformance of the smallest sized cohort of stocks over the past decade plus.
As illustrated in the accompanying chart, mid-cap stocks have delivered higher returns than large-cap stocks over the past two decades, a testament to their potential for business growth and scalability. Concurrently, they have exhibited lower volatility than small-caps, reflecting a greater level of stability due to more developed business models. The inclusion of mid-cap stocks in an investment portfolio can be a strategic decision. When combined with small-caps, mid-caps can provide balance, enhancing the potential for return within a portfolio while simultaneously helping temper volatility.
20 Year Risk/Return by Market Capitalization
As of 10/31/2023
Source: Morningstar. Total return and standard deviation are annualized. Large-cap represented by the Morningstar Large Cap Index, Mid-cap represented by the Morningstar Mid Cap Index, Small-cap represented by the Morningstar Small Cap Index. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index. Past performance is no guarantee of future results. See disclaimers and descriptions at bottom of page.
Distinct Sector and Growth Drivers
Another attractive characteristic of mid-caps is differentiated sector exposures relative to large-caps, providing diversification and distinct drivers of growth. In particular, technology names tend to be much less prevalent in the mid-cap segment of the U.S. equity market, accounting for less than 15% of the universe. In contrast, the technology sector makes up an astonishing 31.5% of the large-cap segment. This difference is especially important today given the concerns that the increasing dominance of technology companies within large-caps is creating concentration risk for investors.
Beyond less tech, mid-caps also feature notable exposure to both the industrials and materials sectors, which are underrepresented in the large-cap universe. These are sectors that may be poised for growth in the coming years as the U.S. government has passed stimulus bills aimed at building-out U.S. manufacturing capabilities. This stimulus spending has come in the form of the $1 trillion Infrastructure Investment and Jobs Act, the nearly $400 billion in clean energy spending in the Inflation Reduction Act, and the $280 billion CHIPS and Science Act. These stimulus measures are expected to bring growth to manufacturing hubs across the nation, benefiting companies in the industrials and materials space, and mid-caps are positioned to capture a considerable portion of this expansion.
Small-caps also exhibit much of these same differentiated sector exposures; however, the greater stability of mid-caps leads to them as the less volatile medium to pursue the above opportunity given today’s uncertain economic environment and recessionary risks.
Technology Sector Dominates Large-caps
As of 10/31/2023
Source: Morningstar. Large-cap represented by the Morningstar Large Cap Index, Mid-cap represented by the Morningstar Mid Cap Index, Small-cap represented by the Morningstar Small Cap Index. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index. Past performance is no guarantee of future results. See disclaimers and descriptions at bottom of page.
Valuations Not Seen in Decades
One of the most compelling reasons to consider allocating to mid-caps is their extremely low valuations on a both historical and relative measure. Hawkish monetary policy, economic uncertainty and fears of recession have had an outsized impact on the share prices of smaller companies relative to those at the top of the market cap spectrum. Mid-cap stocks are now trading at valuations not seen in decades when compared to their large-cap counterparts.
To put this valuation opportunity into perspective, as of October 31, 2023, mid-caps were trading at 12.9 times earnings, well below their long-term 20-year average of 18.3 times. In contrast, large-caps were trading at 19.1 times earnings, well above their 20-year average of 17.5 times earnings.1 Based on those numbers, mid-caps are trading at nearly a 30% discount to their long-term average and an even greater relative discount to where large caps sit today. This presents a valuation opportunity not seen in over 20 years.
Mid-Cap P/E Ratio Relative to Large-Cap P/E Ratio
Jan.1997 – Oct. 2023
Source: Bloomberg. Mid-cap represented by the S&P Midcap 400 Index. Large-cap represented by the S&P 500 Index. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index. Past performance is no guarantee of future results. See disclaimers and descriptions at bottom of page.
While small- and mid-cap stocks often bear the brunt of recessionary fears, they also tend to bounce back as the storm clouds clear. Now may be an opportune time to allocate capital to attractively priced mid-caps, especially at a time when large-cap valuations could be considered stretched.
Access Quality Mid-Cap Companies with Attractive Prices
While the allure of large-cap stability and the growth potential of small-cap is undeniable, investors should not overlook the often-underappreciated mid-cap segment. Mid-cap stocks offer a unique combination of growth potential, stability, differentiated sector exposure, and are trading at very attractive valuations. A tilt toward mid-cap equities can provide a complement to the traditional large- and small-cap barbell.
For investors looking to access mid-cap equities, the VanEck Morningstar SMID Moat ETF (SMOT) is a viable option offering exposure that emphasizes both quality and valuation. SMOT seeks to track the Morningstar® US Small-Mid Cap Moat Focus IndexSM, which targets small- and mid-cap companies that possess long-term competitive advantages, known as moats, and that are trading at attractive prices. Because companies with a moat are typically larger, more-established entities, the strategy tends to skew towards mid-caps. While small-cap companies are still eligible for inclusion, the hurtle of developing a moat acts as a quality screen, limiting exposure to only those select small-caps able to do so.
Originally published 22 November 2023.
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Source for all data unless otherwise noted: Morningstar.
1 Source: Bloomberg. Mid-cap represented by the S&P Midcap 400 Index. Large-cap represented by the S&P 500 Index.
Fair value estimate: the Morningstar analyst’s estimate of what a stock is worth. Price/Fair Value: ratio of a stock’s trading price to its fair value estimate.
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