Mid-Cap Stocks: The Market’s Sweet Spot

Tom Kolefas, CFA, Managing Director and Lead Portfolio Manager, TIAA-CREF Mid-Cap Value Fund and Ted Scalise, CFA, Managing Director and Lead Portfolio Manager, TIAA-CREF Mid-Cap Growth Fund

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Mid-cap stocks can be a valuable addition to a diversified portfolio. Tom Kolefas, Lead Portfolio Manager of the TIAA-CREF Mid-Cap Value Fund, and Ted Scalise, Lead Portfolio Manager of the TIAA-CREF Mid-Cap Growth Fund, answer some frequently asked questions about investing in mid-cap stocks.

What are mid-cap stocks?

Mid-cap stocks are generally defined as shares of companies with market capitalizations of between $1 billion and $15 billion. Approximately 1,500 of the stocks within the U.S. equity markets are mid-cap stocks. There are about 11,200 U.S. stocks in all, of which nearly 9,500 are small- or micro-cap issues.

What are the main benefits of investing in mid-cap stocks?

We believe mid-cap stocks are in the “sweet spot” of the investment universe, combining attractive attributes of both large and small companies. Typically, mid-cap companies are large enough to have seasoned management teams, sophisticated information technology, broad distribution channels, strong overall market presence and ready access to capital markets — advantages that very small or start-up companies may lack. At the same time, mid-cap companies can grow more quickly than their large-cap counterparts, benefiting from potentially less bureaucracy, fewer layers of management and generally a more entrepreneurial spirit that can help speed decision-making.

In addition, mid-cap firms are sometimes acquired by larger companies looking to grow faster, capture market share, offer new products, enter new markets, gain economies of scale or obtain intellectual property quickly. They also are more likely to benefit from management buyouts in which private equity firms purchase mid-cap companies; when successful, leveraged buyouts can potentially boost investment returns.

What is the difference between mid-cap value and mid-cap growth stocks?

Generally, value stocks are those trading at low prices relative to the company’s earnings, cash flows, sales or book value. Growth stocks tend to trade at higher valuations as the market recognizes the growth potential of the company (demonstrated superior growth in revenues, earnings, cash flows or book value relative to their peers).

Value and growth companies tend to behave differently at different points in the economic cycle. When the economy is enjoying a robust expansion, earnings growth tends to be strong across multiple sectors and companies. In such an environment, it may be advantageous to invest in companies with the lowest price-to-earnings (P/E) ratios, an approach that favors value. In contrast, in a slowing or declining economy, earnings growth is scarce, and investors generally migrate to the few stocks and sectors that are showing stronger earnings growth and thus have higher P/E ratios. This environment generally favors growth companies. In an economic downturn, therefore, mid-cap growth can be expected to outperform mid-cap value.

What role can mid-cap stocks play in a diversified investment portfolio?

Mid-cap stocks historically have produced returns that are higher than large-cap returns and almost as high as small-cap returns, with only slightly more volatility than large-cap stocks, according to FactSet. In other words, mid-cap stocks have historically offered a favorable risk/reward tradeoff versus both large- and small-cap stocks. Therefore, depending on an investor’s time horizon, mid-cap stocks could potentially play a number of different roles in a portfolio:

  • As a core component of a long-term (10+ years) investor’s equity exposure
  • To diversify a larger-cap equity portfolio for investors with a shorter time horizon or greater risk aversion
  • To reduce risk in a small-cap equity portfolio for either long- or short-term investors

What are some of the factors an investor should consider when selecting a mid-cap fund?

In our opinion, it is important to determine the degree to which an actively managed fund tends to deviate from its benchmark. An active manager seeks to provide risk-adjusted performance that exceeds the benchmark, but we believe it is critical to be near the benchmark in order to capture the attractive long-term return potential of an asset class. The fund manager should be able to demonstrate a repeatable methodology and process that has over time added incremental return above and beyond the benchmark, keeping in mind of course the prospective investor’s unique circumstances, investment time frame, objectives and risk tolerance. A long-term track record, low fees and generally low portfolio turnover are other important factors to consider.

Are there any current issues that could affect mid-cap stock performance?

A high-visibility issue in the mid-cap arena is the tremendous cash build-up on American corporate balance sheets, which is particularly acute in the mega-cap and large-cap sectors. Along with very low borrowing costs for strategic buyers (and to a lesser degree, private equity funds), these cash levels give large-cap companies the buying power they need to acquire mid-cap companies. Acquisition activity has the potential to enhance the returns of mid-cap stocks.

What is TIAA-CREF’s mid-cap investment philosophy?

Overall, we adhere strongly to style and market-cap purity within both our Mid-Cap Value and Mid-Cap Growth Funds. The funds’ portfolios are constructed using a benchmark-aware approach, and both funds operate within an established risk profile. The portfolio management teams are compensated based on their ability to provide risk-adjusted returns above the benchmark. The funds pursue their own respective strategies for active stock selection in an effort to outperform their respective benchmarks.

For the TIAA-CREF Mid-Cap Value Fund, this includes a focus on low-valuation stocks with high free-cash-flow yields, low debt leverage and specific catalysts demonstrating that company management is using the free cash flow to enhance shareholder value. Our overall philosophy is to maintain financial and decision-making flexibility; free cash flow is the vehicle with which management can close the gap between its stock price and the intrinsic value of the underlying company.

For the TIAA-CREF Mid-Cap Growth Fund, our philosophy is based on the premise that earnings drive stock prices, and, as a result, the faster a company’s earnings grow, the faster its stock price will appreciate. To construct the fund’s portfolio, we aim to identify companies that are growing at a rapid pace, while trading at a reasonable valuation relative to their growth rate.

The valuation of the company should be reasonable relative to its growth prospects. The measure we use to evaluate this metric is the price-to-earnings-to-growth, or PEG, ratio. The higher the growth rate imbedded in any particular PEG ratio, the more attractive the valuation, with lower PEGs preferred to higher PEGs.

What are some of your current investment themes for mid-cap growth and mid-cap value stocks?

For mid-cap value stocks, we see attractive long-term potential among aerospace suppliers due to the long-term nature of the replacement cycle of commercial jets.

Oil service companies — offshore drillers and companies that supply them, broad oil-service companies, and capital goods companies with a greater focus on safety devices such as blow-out preventers — are also compelling, because of a long-term cycle of rising demand from the emerging markets.

U.S.-based commodity and specialty chemical companies are attractive, as cheaper shale natural gas and the weaker dollar have made the U.S. highly competitive in the global chemical industry. Enhanced export volumes and pricing are also helping the relative earnings of these companies.

In terms of mid-cap growth investment themes, the current backdrop of slower economic growth may benefit companies that deliver products and/or services that support more efficient ways of doing business.

Firms specializing in automation equipment can enable cost-cutting through standardization of processes, such as software firms that provide corporations with solutions and the ability to pay on a per-user-per-month basis. Also, cloud-based computing is transforming how companies store and manipulate data by enabling the virtualization of servers.

Luxury retail and other high-end consumer products have held up well in sluggish economic conditions. As the economy improves, we believe an even greater percentage of the population should have the confidence to begin spending money.

We also believe that firms specializing in either physical or electronic security systems may provide attractive long-term growth potential, as criminals are getting better at circumventing existing security measures.

What is your outlook for mid-cap stocks?

Our outlook for mid-cap stocks in 2012 is relatively upbeat, assuming the global economy does not experience another deep recession like the 2008-2009 downturn. There are enough positive signs in the U.S. economy (including rising incomes, employment, manufacturing and capital spending) for us to believe that the U.S. can sustain a 2% to 2.5% economic growth rate in 2012. Looser monetary policy in China and Europe could further boost U.S. economic performance. If our outlook is correct, mid-cap stocks – because of their faster earnings growth, strong balance sheets, and shareholder-friendly actions, along with merger, acquisition and leveraged buyout possibilities – could continue to provide attractive long-term return potential.

Do you have any takeaways for investors?

Mid-caps are often underappreciated by investors and under-followed by analysts. Much of the industry analysis and academic literature emphasizes either larger companies (such as those represented in the S&P 500 Index) or small-caps (as in the Russell 2000 Index). And yet, over long investment time horizons, mid-cap stocks tend to outperform large-caps, though with slightly more volatility. Over a 10-year period, the Russell Mid Cap Index posted annualized returns of 6.99%, outpacing the S&P 500 Index (2.92% annualized returns), the Russell 1000 Large Cap Index (3.34% annualized returns), and the Russell 2000 Small Cap Index (5.62% annualized returns), according to FactSet. As such, investors may find them to be an effective diversifier of both large- and small-cap portfolios.

The stocks of mid-capitalization companies often have greater price volatility, lower trading volume, and less liquidity than the stocks of larger, more established companies.

Mid-cap growth stocks can perform differently from the market as a whole and other types of stocks. Growth stocks can also be more volatile, and experience sharper price fluctuations, than other stocks.

Mid-cap value stocks believed to be undervalued are subject to the risks that the issuer’s potential business prospects are not realized and its potential value is never recognized by the market. As a result, value stocks can be overpriced when acquired and may not perform as anticipated.

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