Golfers refer to the “sweet spot” as the position on the face of the clubhead that when hit produces the maximum result. A very similar result occurs when investing in mid-cap stocks, those companies with market capitalizations ranging from $ 2 billion to $ 10 billion. Most of the time, they are established businesses sandwiched between slower-growing large-cap multinationals and faster-growing small-cap businesses.
In recent years, mid-cap stocks have outperformed their large- and small-cap peers with very little added risk. It is as if they have reached the optimum point of action. In this article, we examine the key attributes of mid-cap stocks, including how to analyze them and why you should consider these often misunderstood stocks for your portfolio.
Why include it in your portfolio
Having already established that the historical performance of mid-caps equals or, in many cases, better than large and small caps, it is important to note that performance is not the only reason to include midcaps in your portfolio. Several others make them really very tempting. For example, most mid-caps are simply small caps that have grown. The additional growth makes them the stepping stones to becoming large-cap companies. Part of the growth is obtaining additional financing to drive expansion. Mid-cap companies generally have it easier than small caps.
While mid-caps have an advantage over small ones when it comes to fundraising, their advantage over large caps equates to earnings growth. Smaller in size, mid-cap companies often have not yet reached the stage of maturity where earnings decline and dividends become a more important part of a stock’s total return. Possibly the most overlooked reason for investing in mid-caps is the fact that they receive less analyst coverage than large caps. Some of the best performing stocks historically have been unloved companies that suddenly became loved, producing the institutional buyers needed to raise their price. Some call this the “money flow.” Call it what you want, institutional support is vital to raising the share price. These big players can create and destroy shareholder value. In the end, investing in mid-cap companies makes sense because they give investors the best of both worlds – small-cap growth combined with large-cap stability.
One of the beautiful things about mid-cap stocks is that you are investing in businesses that are generally profitable, have been for some time, and have experienced management teams. This does not mean that they have stopped growing; conversely, mid-cap earnings tend to grow at a faster rate than those of the small median cap while doing so with less volatility and risk. In addition to earnings growth, it is important to find stocks whose earnings are sustainable for many years. That’s what turns a mid-cap into a large cap. Telltale signs that a company’s profits are going in the right direction include higher gross margins and operating margins combined with lower inventories and accounts receivable. If you routinely change your inventory and accounts receivable faster, this generally leads to higher cash flow and higher profits. All of these attributes help reduce risk. Mid-cap stocks tend to possess these attributes more often than other stocks.
Regardless of the size of the stocks you are interested in, it is important to invest in companies with strong balance sheets. Famed investor Benjamin Graham used three criteria to assess the financial health of a company:
- Total debt less than tangible book value. Tangible book value is defined as total assets less goodwill, other intangible assets, and all liabilities.
- A common ratio greater than two. Current ratio is defined as current assets divided by current liabilities. It is an indication of the ability of a company to meet its short-term obligations.
- Total debt less than twice the NAV. Companies that meet this criterion can pay off their debts with cash and other current assets, which makes them much more stable.
Given the unpredictability of business, a strong balance sheet can help companies survive lean years. Because mid-caps tend to have stronger balance sheets than small caps, this reduces risk while providing higher returns than large caps. By investing in mid-caps, you are in a sense combining the financial strength of a large cap with the growth potential of a small cap, often resulting in an above-average return.
Revenue and profit growth are the two most important factors in long-term profitability. In recent years, mid-cap stocks have outperformed both large-cap and small-cap stocks due to their superior growth on both the top and bottom lines. Industry experts suggest that mid-caps can produce better returns because they are quicker to act than large caps and more financially stable than small caps, providing a double boost in the pursuit of growth.
Investors interested in mid-cap stocks should consider the quality of income growth when investing. If gross and operating margins increase at the same time as revenue, it is a sign that the company is developing greater economies of scale that result in higher profits for shareholders. Another sign of healthy income growth is lower total debt and higher free cash flow. The list goes on, and while many of the criteria investors use to evaluate stocks of any size definitely apply here, it’s critically important with mid-caps that you see progress on the earnings front because that’s what. that will make it a large cap. . Income growth is important, but profit growth is vital.
Nobody wants to overpay when they buy, and buying stocks is no different. Warren Buffett believes that “it is much better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Many refer to people interested in growing at a reasonable price as GARP investors. Some of the things GARP investors focus on when evaluating mid-cap stocks include growth measures such as sales and earnings growth rates along with value measures such as price / earnings and price / cash flow. Regardless of the measures you choose, the most important criterion should be the quality of the company. As the Oracle of Omaha says, there is no point in getting a lot out of a failed endeavor. High-value investors may disagree, but true GARP fans are simply looking to avoid overpaying, not getting the deal of the century.
Shares or Funds
Investing in mid-caps is a great way to simultaneously diversify and improve the performance of your investment portfolio. Some investors will find that there is too much work involved in evaluating individual stocks, and if that’s you, an excellent alternative is to invest in exchange-traded funds or mutual funds, leaving the professionals to handle the evaluation process. Whatever your preference, mid-cap companies are definitely worth considering.