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Philip van Doorn

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Sept. 23, 2019, 10:21 a.m. EDT

How to profit from the ‘best of both worlds’ in stock investing

Mid-cap companies can offer large-cap quality with small-cap growth

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By Philip van Doorn, MarketWatch


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Planet Fitness is the largest holding of the new Alger Mid-Cap Focus Fund.

After a 10-year rally for large-cap stocks, a way to diversify your investments and reduce short-term risk is to increase exposure to mid-cap shares.

We recently discussed the long-term outperformance of value stocks and equally weighted index funds — two areas to consider if you wish to cut risk by diversifying beyond the market-capitalization-weighted S&P 500 Index /zigman2/quotes/210599714/realtime SPX +1.40% . (The S&P 500 isn’t as diversified as its name implies because the index’s five largest companies — Microsoft /zigman2/quotes/207732364/composite MSFT +2.86% , Apple /zigman2/quotes/202934861/composite AAPL +3.32% , Amazon /zigman2/quotes/210331248/composite AMZN +2.65% , Alphabet /zigman2/quotes/205453964/composite GOOG +1.78%   /zigman2/quotes/202490156/composite GOOGL +1.80%  and Facebook /zigman2/quotes/205064656/composite FB +1.47%  — make up 17% of the market value.)

Leaving cap-weighting aside, mid-cap stocks are often overlooked, despite good performance characteristics.

Amy Zhang, who manages the Alger Small Cap Focus Fund /zigman2/quotes/207263247/realtime AOFAX +1.07%  (which has had an incredible performance run) launched the Alger Mid-Cap Focus Fund /zigman2/quotes/212840468/realtime AFOIX +1.66%  in June. In an interview at her office in New York, she said mid-cap stocks offered “the best of both worlds,” with quality “close to large-cap” stocks, while the group’s growth “is closer to small-cap.”

She also discussed, below, three of the companies held by the Alger Mid-Cap Focus Fund.

Crit Thomas, global market strategist at Touchstone Investments in Cincinnati, said in a phone interview that mid-cap stocks were “under-represented” in investors’ portfolios as money continues to flow into large-cap index funds. He then helped to explain basic misunderstandings of the Russell 1000 Index /zigman2/quotes/210598144/delayed RUI +1.40% , which consists of the largest 1,000 stocks in the Russell 3000 Index /zigman2/quotes/210598149/delayed RUA +1.34% .

People often speak of the Russell 1000 as a large-cap index, but it also includes mid-cap stocks. The largest 200 companies in the index account for 73% of the Russell 1000’s market capitalization. This group is called the Russell Top 200 Index /zigman2/quotes/210598138/delayed XX:RT200 +1.66% . The remaining 800 make up the Russell Mid-Cap Index /zigman2/quotes/210598151/delayed RMCC +0.63%

Here’s a 15-year comparison of total returns (with reinvested dividends) for the Russell Mid-Cap Index against the Russell Top 200 Index, the full Russell 1000 and the S&P 500:


FactSet

Here’s a performance comparison for the indexes for different periods:

Index Total return - 2019 through Sept. 18 Average return - 3 years Average return - 5 years Average return - 10 years Average return - 15 years Average return - 20 years
Russell Mid-Cap Index 23.3% 11.9% 8.7% 13.1% 10.0% 9.3%
Russell Top 200 Index 21.2% 15.0% 11.0% 13.3% 8.8% 5.5%
Russell 1000 Index 21.8% 14.1% 10.4% 13.2% 9.2% 6.5%
S&P 500 Index 21.7% 14.3% 10.6% 13.2% 9.0% 6.2%
Source: FactSet

So the mid-cap group has been the best performer for 15 and 20 years, while trailing over the past 10 years, during the post-crisis recovery and the central-bank-driven bull market.

Why mid-cap stocks now?

Reasons to broaden your horizons beyond large-cap stocks, which have worked so well during recent years, include lowering your risk via diversification, especially if you are worried about a significant decline for the stock market. But Thomas pointed out that better earnings growth and better expected earnings growth might also make this an excellent time to consider mid-caps.

From a base line in calendar 2015, here are actual cumulative earnings-per-share growth figures for the Russell Mid-Cap Index and the Russell Top 200 Index through the past three full calendar years, with projected earnings growth through the next three full years, based on analysts’ consensus estimates:

Russell Mid-Cap Index Russell Top 200 Index
2016 3.1% -2.9%
2017 15.3% 8.1%
2018 40.9% 38.6%
2019 Estimate 61.4% 48.0%
2020 Estimate 79.1% 64.1%
2021 Estimate 98.4% 82.1%
Source: Bloomberg

The mid-cap group is expected to remain the earnings growth winner, justifying its inclusion in a broad equity investment strategy.

In summary, Thomas called mid-caps ”the best-performing asset class in terms of market cap within equities.”

“These companies are less cyclical because they are a bit larger than small-caps,” he said. “They have a little bit more diversification, which gives them more stability. They are not as deeply indebted.”

He added that their relatively small sizes, when compared with large-cap companies, mean “there is room for growth.”

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