Jewish World Review May 8, 2002 / 27 Iyar, 5762
James K. Glassman
There's more to the stock market than gigantic, brand-name companies with tens of billions of dollars in sales and tiny, racy start-ups without any profits. In between these extremes lie mid-caps -- the Goldilocks stocks. They're not too big, not too small, not too hot, not too cold. They're just right.
Imagine that at the start of 1999, you put $10,000 into the Standard & Poor's 500-stock index, made up of the largest U.S. companies. Three years later, your account dropped to $9,432. Do the same with the Russell 2000 index of small-company stocks and you have $12,046. But a $10,000 investment in the S&P Mid-Cap 400 index rose to $15,653.
One of the best of the mid-cap mutual funds, T. Rowe Price Mid-Cap Value, returned 14 percent last year, beating the S&P 500 by 26 percentage points and the Russell by 12. It's returned 10 percent for the first four months of 2002. David Wallack, the fund's manager, believes the sector is still undervalued even after its big recent run-up. More important, he thinks mid-caps have inherent advantages over both bigger and smaller stocks. "They are more nimble than larger companies," he says, "and they are more mature and less volatile than smaller companies."
The long-term history of the stock market shows that the smaller the company, the higher the return. But it also shows that smaller the company, the more volatile the investment. In other words, you get paid for taking risks -- which makes sense. But over the past two decades, mid-caps have whipped both large-caps and small-caps. Raymond James & Associates recently produced a chart titled "Cyclical Nature of Index Performance," with the intention of showing how nine categories -- including large, small, growth, value and international stocks -- rotated as market leaders over the past 20 years. True enough. But what's striking about the data is that while the Standard & Poor's Mid-Cap 400 never led the list in any one year, it ended up No. 1 on average for the entire 1981-2001 period, with an annual return of 16.9 percent, compared with 15.2 percent for the S&P 500 and 12.0 percent for the Russell 2000.
This could be a fluke. I prefer to believe that mid-caps are enjoying their season in the sun but that the season won't last forever. Shadows will fall; they always do. No, the main reason to own mid-caps is not that they will always beat large-caps and small-caps, but that they offer an attractive blend of return and risk -- and, not coincidentally, the sector includes lots of wonderful, underappreciated companies.
A stock's "cap," or market capitalization, is its value (not including debt) according to stock investors. The mid-cap range is not precisely defined, but it's generally accepted as between $1 billion and $12 billion. That's the happy hunting ground for investors.
One of the largest holdings in Wallack's portfolio, for example, is Diamond Offshore, which owns a large fleet of rigs that it leases to big oil and gas companies for deep-water drilling. With a market capitalization of about $4 billion and more than $1 billion in cash and short-term investments, the company has a gorgeous balance sheet. Also, as Wallack points out, "the Tisch family owns over 50 percent of the stock, and I trust them to be good stewards of capital." (The Tisches, who are famous bargain hunters, run Loew's, which in turn owns, in addition to its Diamond majority, Lorillard, the tobacco company, a chain of hotels and CNA Financial.) Diamond was trading at about $32 late last week, but Wallack says it has "earnings power of $5 per share."
The T. Rowe Price fund also owns a large dose of Aetna, the second-largest health insurance company in the country -- a firm that's been around 150 years. Aetna, with a market cap of $6 billion, lost money last year, but Wallack says it's improving. Indeed, the stock has jumped 50 percent since February.
Another mid-cap enthusiast is Chris Bonavico, who manages Transamerica Growth Opportunities Fund -- which just changed its name, eliminating the phrase "Small Company." The new moniker removes a confusion, but the fund's focus is the same: Bonavico, manager since inception in 1998, looks for what he calls "SMIDs" -- small-to-mid-cap firms, or, more precisely, larger small-caps that have a good chance to grow into mid-caps. When these smaller companies reach mid-cap status, Bonavico, who is a buy-and-hold kind of guy who aims to keep his stocks an average of three years (vs. a one-year average for the typical fund), doesn't want to be forced to sell them, as he would with a strictly small-cap portfolio. I like this approach, and it works. For the year ended March 31, 2002, the fund ranked first in the mid-cap growth category (among 466 funds) according to Lipper, returning 34.1 percent.
"This is the sweet spot in the market," Bonavico says. "These are companies that are under-followed [by Wall Street analysts] and undervalued." His top holdings include Investment Technology Group, a remarkable company (market cap: $2.3 billion) that allows institutional investors to trade stocks among themselves, cutting costs and maintaining anonymity by bypassing exchanges. "This is a business with the wind at its back," Bonavico says. "We called the top brokerage analysts and they didn't get it." That's what he likes to see -- a firm that is not understood by Wall Street -- so he can buy shares at a low price before other investors wake up.
He also owns Moody's Inc. "This is a phenomenal business," he said. "The credit-rating agency has little competition, and "the secular trend" -- that is, the long-term tendency of companies toward issuing more public debt that needs a Moody's rating -- "is running in its favor." Last year, revenue rose 32 percent. But, with a market cap of $7 billion, Moody's is followed by only a handful of analysts, so its valuation remains moderate despite a price that's nearly doubled in two years.
Bonavico's fund also owns Techne Corp., a smaller mid-cap ($1.1 billion). Techne provides biotech firms with proteins for experiments. It offers a way to bet on the boom in new pharmaceuticals without trying to pick winners and losers among the drug companies themselves. Bonavico looks for companies with high returns on invested capital, and Techne's is an amazing 45 percent (in other words, when it puts $1,000 in new money to work, and it produces $450 in annual profit). Further good news is that, while net income rose 16 percent in the most recent six months, the stock price is languishing (it's got "tech" in its name, after all).
Expeditors International of Washington is also in Bonavico's portfolio. With a $3 billion market cap, this company helps global firms send their products around the world, handling all the complicated logistics. It's a "non-asset-based, high-returning business," says Wallack. In other words, Expeditors does not have to plow profits into planes, ships or factories. It, too, has no long-term debt. Shares are up 40 percent from September's low, but they're still well below the 52-week high.
While many small-cap investors search for younger companies with a chance to take off, mid-cap advocates tend to like tried-and-true firms, often in boring businesses. Dow Theory Forecasts newsletter last month listed what it calls the "best mid-cap blue chips" -- many of which fall into the conservative category. Among them: SunGard Data Systems ($9 billion market cap), which processes transactions for brokers and has boosted its earnings annually for more than 15 years; Henry Schein Inc. ($2 billion), consistently profitable provider of health-care products and a longtime favorite of mine; and Biomet Inc., maker of orthopedic devices that has increased its earnings every year since 1987, from 3 cents to 79 cents a share.
In addition to the T. Rowe Price and Transamerica mutual funds, the best of the mid-cap group, according to Morningstar's analysts, are Invesco Dynamics, Janus Enterprise, Longleaf Partners, Morgan Stanley Institutional Mid-Cap Growth, Oak Value and Tweedy Brown American Value.
In fact, the sector is full of interesting smaller funds, including Meridian Value, with double-digit returns in each of the past seven years; the Al Frank Fund, run by the editor of the excellent eponymous newsletter and returning an amazing annual average of 37 percent over the past three years; and Muhlenkamp, up 8 percent so far in 2002, with holdings like NVR Inc. (market cap: $2.8 billion), a home builder and mortgage banker based in McLean.
Another approach is to buy exchange-traded funds (ETFs) -- especially iShares, which are portfolios containing the stocks of a popular index. One iShares EFT tracks the S&P 400 Mid-Cap Index (symbol: IJH) and has returned 26 percent over the past six months, with an expense ratio of only 0.2 percent. Another mid-cap ETF, with similar returns and expenses, tracks the Russell Mid-Cap index (symbol: IWR). As a more conventional index mutual fund, Vanguard offers the Midcapitalization Index, with an expense ratio of just 0.25 percent.
But remember the risk-reward tradeoff. Between 1926 and 2001, according to Ibbotson Associates, the stocks with the largest market caps returned an annual average of 10.7 percent. Mid-caps returned 11.4 percent. Small-caps returned 11.7 percent, and micro-caps, the smallest of the small, returned 12.5 percent.
As caps decline, risk rises. Consider standard deviation, which measures how much the annual returns of a stock vary from the stock's average return. For large-cap stocks, standard deviation is about 20 percent, which means that in two-thirds of the years, you can expect returns to fall in a range from about minus-10 percent to about plus-31 percent. In other words, 20 percentage points lower and 20 percentage points higher than the average of 10.7 percent.
With mid-caps, standard deviation was 25 percent; small-caps, 30 percent; micro-caps, 39 percent. I don't mind a little risk, and, as a result, I see mid-caps striking the right balance. But many investors can't stand the high volatility of smaller stocks. After all, S&P 500 stocks represent more than 80 percent of the capitalization of the entire market, so you can stick to these large companies and still get adequate diversification. But it would be a real pity to pass up mid-caps.
In last week's column, I gave the wrong symbol for Japan i-Shares, an exchange-traded fund that invests in the MSCI index of Japanese companies. The correct symbol on the American Stock Exchange is EWJ.
JWR contributor James K. Glassman is the host of Tech Central Station. Comment by clicking here.
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