Mid-Cap Companies in Today’s Market
“We are net sellers of large and megacap companies and buyers of intermediate companies.” This perspective was shared by Brian Selmo from First Pacific Advisors during a recent appearance on the Morningstar podcast, A Long View. He emphasized his approach as a bottom-up inventory picker, identifying opportunities where evaluations look favorable. According to Selmo, he’s discovering “classically good businesses” in the current market — those that are economically stable, well-managed, and valued between 8x to 14x revenues, with market capitalizations above $30 billion.
The equity research team at Morningstar seems to echo Selmo’s perspective, noting that mid-caps might hold more value than their larger counterparts. In their recent analysis, they found significant overrated large caps, valuable mid-caps, and a few an undervalued segment, while pointing to challenges that small caps face with the ongoing high-interest rates and economic uncertainty.
This brings us to considering mid-range companies in the U.S. stock market. The Morningstar US Midcap Index has underperformed compared to large caps over the past few years but has shown better performance against small caps recently.
So, it could be that better days are on the horizon for mid-caps, but the necessary question remains: do investors need a distinct mid-cap allocation?
Mid-Cap Market Dynamics
I have to say, I was a bit taken aback by the mention of a $30 billion market cap in relation to mid-caps. It’s clear I haven’t been paying enough attention to the shifts occurring within the U.S. market.
The Morningstar US Midcap Index currently includes components with a maximum market cap of over $100 billion. Morningstar essentially defines the caps within relative terms: large caps make up the top 70% of the market, mid-caps the next 20%, and small caps fall below that. After the recent index restructuring in June, several intriguing data points about these capital ranges came to light.
This data reveals something pivotal about the current market. Over the last decade, larger companies have maintained dominance, with giants amassing market caps exceeding $1 trillion. What’s more, the Morningstar US Midcap Index has shrunk considerably from its previous count of 623 components in mid-2015, resulting in a concentrated spread in terms of stock and sector weight, coupled with reduced profitability and lower price/revenue multiples.
The character of mid-cap space is quite fluid. The Morningstar US Midcap Index includes smaller companies that have experienced rapid growth, while larger entities like Royal Caribbean and Lululemon have seen downturns. Recent IPOs and spinoffs also add to the mix, such as CoreWeave and Kenvue.
If you look closely, technology is the largest driver for mid-cap success. Firms like Palantir and Marvell have moved up to the large-cap space, significantly boosting the returns for the MID-CAP index over the past decade. However, this has paradoxically benefited the larger caps as well, with companies like NVIDIA and Microsoft achieving massive gains, reinforcing the ongoing trend.
This paints a picture where large caps continue to grow larger, overshadowing smaller tech stocks, which might be struggling.
Future Prospects for Mid-Caps
Looking ahead, one lesson this decade has taught us is that significant growth potential remains for larger caps. Sure, growing from a smaller base typically has its advantages, but we’ve also seen certain companies skyrocket to staggering valuations in no time, seemingly dismissing warnings of bubbles.
Yet, historical data suggests that smaller caps will often outperform their larger counterparts over extensive periods. The concept of “Size Premium” indicates that fewer stocks often translate into greater compensation for investor risk. After the tech bubble burst in 2000, this was noticeably evident in smaller U.S. caps.
Current assessments of mid-cap stocks reflect a considerable divide between growth-focused and more reasonably valued stocks. Analysts look at names like Vistra, Roblox, and Take-Two Interactive as trading at premiums, while others, like Clorox and Zimmer Biomet, are seen as value opportunities.
The Role of Mid-Cap Stocks in Portfolios
It’s interesting — mid-sized firms can sometimes get overlooked in the grand shuffle of portfolios. Though small caps are generally recognized as a distinct asset class, many investors may not actively allocate to mid-cap stocks. There’s some merit to this approach.
Many likely have moderate exposure through broader U.S. equity funds, and some passive strategies allow for mid-cap inclusion depending on the index they follow. However, managers’ trends often wander through the various market capitalizations, with options like the Morningstar US Large Mid Cap Index serving as a more relevant benchmark instead of purely large cap-focused strategies.
In general, mid-caps tend to correlate more closely with the broader market than small caps do. Therefore, when it comes to diversifying a portfolio, mid-caps don’t add as much value.
It’s crucial to remember that correlation coefficients, while informative of direction, don’t indicate magnitude. Even if mid-caps move similarly to larger caps, their scale may be very different. There’s a possibility that large caps’ long-term performance may change.
Currently, there’s a discussion about re-evaluating the size of large companies and potentially adjusting market cap allocations for strategic positioning. Stock pickers, like Selmo, tend to favor a selective approach when looking at asset classes. According to my analyst colleagues, plenty of compelling and well-valued stocks exist in the mid-space.
