From the July 2009 issue of Wealth Manager Web • Subscribe!

July 1, 2009

Sweet Spot in the Middle

Somewhere between a sagging economy and a skittish stock market, investors at this hour are, well, a bit stuck...trapped in the ultimate risk/reward dilemma: Do I take a conservative approach that will protect me on the downside but might make me miss out on a market recovery, or do I aggressively go for the upside at the risk of taking a hit if prices head south? The closest thing to an answer, at least in the domestic equity space, might be right in the middle.

It's true--middle capitalization stocks, or "midcaps," have historically produced the best risk/reward profile among their equity brethren. In fact, many money managers refer to midcaps as the "sweet spot" of the stock market, and for good reason. Beyond diversification benefits, midcaps have consistently outperformed large- and small-cap stocks over the past 30 years--with only slightly more volatility than the large-caps and a whole bunch less than the small.

We're all well aware that the Sharpe Ratio is a useful way to compare risk-adjusted returns of various investment classes. Using the market-cap Russell Indexes, we calculate the Sharpe Ratio for mid-cap equities to be 0.31 for the 30-year period ended March 31, 2009; small- and large-cap stocks, meanwhile, produce ratios of 0.17 and 0.23, respectively. So, how are mid-cap stocks able to consistently outperform their small- and large-cap counterparts on a risk-adjusted basis? Let's look at the mid-cap universe.

Falling into the region between small- and large-cap companies, midcaps today generally range from market capitalization between $2 billion and $10 billion. Broadly speaking, mid-cap companies outperform on a risk-adjusted basis because they combine desirable attributes of both their larger and smaller peers: They tend to be in the prime growth phase of their business cycle with positive cash flow and accelerating earnings per share. They typically have seasoned and experienced management teams, established products, reasonable market share, and name recognition. They generally have, in other words, less business risk than small and emerging companies. But collectively, they still offer more growth potential than large, mature companies.

Moreover, mid-cap companies tend to be more focused on their specific niches, giving them an added advantage over larger competitors whose efforts may be thinly spread across a broader array of products and services. And they respond more quickly to new product innovations and changes in the marketplace that spur future growth.

On top of all that, mid-cap companies have started to close the gap between the big boys in the international markets. Portfolio manager Michelle Picard of Geneva Capital Management said recently, "Much of the revenue growth in mid-cap companies will soon come from overseas." With advances in technology and information, there are few barriers for a company--even a mid-sized one--to expand into international markets.

The bottom line is that significant--and specific--advantages exist for companies at the mid-size point in their life cycle. It's really no surprise that the mid-cap segment of the equity market has outperformed its domestic counterparts over time. And with this recent expansion into international markets, it will be no surprise to see even greater separation in the foreseeable future.

J. Gibson Watson III is president and CEO of Denver-based Prima Capital (www.primacapital.com), which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.

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