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

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 SPX, +0.00%.  (The S&P 500 isn’t as diversified as its name implies because the index’s five largest companies — Microsoft MSFT, +1.84%, Apple AAPL, -0.81%, Amazon AMZN, +0.22%, Alphabet GOOG, +0.51% GOOGL, +0.49%  and Facebook FB, +1.06%  — 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 AOFAX, +0.14%  (which has had an incredible performance run) launched the Alger Mid-Cap Focus Fund AFOIX, +0.00%  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 RUI, +0.00%, which consists of the largest 1,000 stocks in the Russell 3000 Index RUA, -0.03%.

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 RT200, +0.08%.  The remaining 800 make up the Russell Mid-Cap Index RMCC, -0.22%.  

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:

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:

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.”

An aggressive approach to mid-cap investing

Amy Zhang manages the Alger Small Cap Focus Fund AOFAX, +0.14%, which has an excellent performance record. (She discussed small-cap stocks in April 2018 and in February 2019.) The fund’s success and rapid growth has led Alger to close the fund to new investors. However, the firm launched the Alger Mid-Cap Focus Fund AFOIX, +0.00%, also managed by Zhang, in June.

One might reasonably expect a mid-cap fund following a very similar strategy to the same manager’s small-cap fund to be a slower grower, but Zhang said that over the long term, “mid-cap as an asset class has the best risk-adjusted return,” and that over short periods, “it can go either way.”

“That is the point of having two products,” she said.

Zhang uses the same “high-conviction” strategy to run the new mid-cap fund, with the top 10 holdings (of 49) making up nearly 30% of total assets as of Aug 31:

Veeva Systems VEEV, +0.55%  has a market cap of $19.3 and is held by both the Alger Small Cap Focus Fund and the Alger Mid-Cap Focus Fund. Zhang stressed the importance of “letting winners run.” She said that Veeva has achieved an operating margin of 28%, and that this was the “highest among SaaS companies.” SaaS stands for software as a service.

Veeva’s Vault system is a cloud-based content-management platform used in the life-sciences industry that has been providing an increasing portion of the company’s total revenue — now more than 50%, according to its second fiscal-quarter earnings release. According to Zhang, Vault has a much higher profit margin than the company’s legacy customer relationship management (CRM) system, which it developed in partnership with Salesforce.com CRM, +0.54%.  

The top holding of the fund is Planet Fitness PLNT, -0.15%, which has a market cap of $5.2 billion. Zhang believes the company still has a very long runway for growing its franchise base from a total of 1,859 stores as of June 30.

“There are not that many great consumer companies [with] franchise concepts,” she said.

Planet Fitness’ advantages include “very seasoned franchisees,” many of whom wish to expand by opening more stores, Zhang said. She said the company had “a rare combination of unit growth and comparable [same-store sales] growth” and that she believed its goal of expanding to 4,000 stores is attainable.

Idexx Laboratories IDXX, +0.39%  is another holding of the Alger Mid-Cap Focus Fund, with a market cap of $23.5 billion. The company focuses on providing diagnostic products to the veterinary industry. Idexx reported a 7% increase in second-quarter sales from a year earlier, while earnings per share were up 17%.

Zhang said that as the largest player in companion animal diagnostic testing, Idexx is uniquely positioned to take advantage of an important secular trend: “There is increasing pet ownership among millennials. There is an increasing notion that pets are part of the family.”

Consider how likely you might be to spare no expense in an effort to help your own beloved cat, dog or other pet.

Zhang called Idexx “a compounder” that she has been following for years. She cited “very strong customer loyalty” and continued share buybacks as attractive features, while emphasizing “the humanization of pets.”

Passive approaches to mid-cap investing

The iShares Russell Mid-Cap ETF IWR, -0.30%  holds all the stocks in the Russell Mid-Cap Index and has annual expenses of 0.29% of assets.

For a non-ETF option, the iShares Shares Russell Mid-Cap Index Fund BRMIX, -0.27%  has the same objective, with a net expense ratio of 0.11%, including waivers. (The fund’s gross expense ratio is 0.13%.)

You might prefer index funds that focus on a smaller subset of the mid-cap world by tracking the S&P 400 Mid-Cap Index MID, -0.19%. Stocks in this index have market caps of up to $14.5 billion, according to data provided by FactSet, while 182 of the roughly 800 stocks in the Russell Mid-Cap Index have market caps above that level, with 96 above $20 billion and 17 above $30 billion.  

Here are some ETFs that track the S&P 400 Mid-Cap Index:

• SPDR S&P Mid-Cap 400 ETF MDY, -0.19%  — expense ratio: 0.24%.

• Vanguard S&P Mid-Cap 400 ETF IVOO, -0.20%  — expense ratio: 0.15%.

• iShares Core S&P Mid-Cap ETF IJH, -0.21%  — expense ratio: 0.07%.

Threre are various ETFs and index mutual funds that track mid-cap indexes and subsets of them. Some may be available through your employer-sponsored retirement account. It is a good idea to check periodically to see what is available in your plan — it may be more flexible than you realize, and you should periodically consider whether your investment allocation is the best one.

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