Why Are Investors Overlooking U.S. Mid Cap Stocks?

Despite Consistently Superior Risk-Adjusted Returns, Mid Caps Are Out of Favor - Creating Opportunity in Challenged Markets

10 Nov, 2015, 08:45 ET from ClearBridge Investments

NEW YORK, Nov. 10, 2015 /PRNewswire/ -- While brand name large cap stocks and cutting edge small cap startups grab the spotlight, mid caps have quietly delivered a track record of outperformance versus their larger and smaller brethren.  Mid cap stocks have outperformed both large caps and small caps over every time period stretching from three years all the way out to 25 years.

Many investment consultants and asset allocators have long overlooked mid cap stocks. Yet data compiled by ClearBridge Investments shows that portfolios incorporating mid caps have delivered higher returns and consistently higher Sharpe ratios than portfolios consisting solely of large and small cap stocks.

"Although investors are generally under-exposed to this asset class, mid caps have consistently generated superior risk-adjusted returns compared to large and small caps," said ClearBridge Investments portfolio manager Derek Deutsch.

"Despite several years of strong performance, we are still seeing excellent opportunities in individual mid cap stocks across many industries."

Since 1996, mid caps have delivered higher annual earnings growth than large and small caps. An effective way to harness this profit power is through a selective approach guided by bottom-up research, Mr. Deutsch suggests.

"Mid cap exposure is best achieved through active management, identifying quality companies with above-average earnings growth driven by innovation and capital discipline, strong free cash flow generation and prudent management," he said. "These characteristics will be increasingly important as the U.S. Federal Reserve continues to withdraw liquidity from the economy, volatility levels normalize and stocks become increasingly valued on fundamentals."

In such an environment, ClearBridge Investments portfolio manager Brian Angerame, who with Mr. Deutsch co-manages the firm's mid cap strategies, underscored the need to choose quality stocks and invest carefully.

"In a flat to down market, the S&P High Quality and Low Quality Rankings Indexes show that high-quality stocks have significantly outperformed low quality," Mr. Angerame reported. "As of September 30, high-quality companies beat low by 5.7 percent year-to-date and 10.7 percent over the last year. As rates rise and markets normalize, we expect low-quality mid caps to underperform."

What makes mid cap stocks attractive? Explanations range from business maturity, since mid cap companies are beyond the risky start-up stage but remain a long way from hitting the growth walls faced by larger companies; to less analyst coverage, creating more potential opportunities to find hidden value.

"These are companies in the prime of their business lifecycle, where the most explosive growth can occur," Mr. Angerame said "This is reflected in the higher aggregate operating earnings per share for mid caps since 1996. That can't be emphasized enough."

ClearBridge analysis indicates the market-leading earnings growth of mid caps is grounded in well-established product lines, as well as larger market shares and more sustainable competitive advantages that can create wider economic moats around their businesses.

"Many mid caps have succeeded because they are simply high-quality companies," Mr. Deutsch said. "They can benefit from greater brand recognition and more experienced management than smaller companies. Longer presence in the marketplace can lead to diversified revenue streams, by product and geography. Healthy earnings growth can help businesses expand and improve future earnings through generation of free cash flow. This in turn enables companies to fund research and development, finance acquisitions, pay dividends or buy back shares, further increasing earnings per share. There's no magic to it. The challenge is finding true high-quality mid caps."  

ClearBridge advocates an active management approach to help investors fully harness the earnings power of mid cap stocks. Active managers can add value by focusing on the quality characteristics that create profitable companies and avoiding inferior businesses. By contrast, passive products track indexes that include many constituents with no earnings.

"Many investors, and some financial advisors, don't realize that 13 percent of companies in the Russell Midcap Index, and 10 percent in the S&P MidCap 400 Index, are unprofitable," Mr. Angerame explained. "Another 21 percent in the Russell benchmark and 18 percent in the S&P lack free cash flow. That's too large a proportion of low-quality companies. We are much more selective."

Profitability is not the only fundamental measure where passive exposures can fall short.  Market-cap weighted indexes are often biased toward the most highly-valued companies within the mid cap range, skewing their valuations higher. Active managers can be more opportunistic in determining entry points, purchasing high-quality companies trading at discounts to their intrinsic value and taking advantage of price dislocations created by market volatility.

ClearBridge considers stability of earnings growth as important as rates of growth.

"We want to own companies that will benefit from long-term compounding of profits," Mr. Deutsch said "We avoid relying on short-term earnings momentum that may flame out if new competition arises or a clinical trial or regulatory action produces a negative outcome."

The current environment is particularly conducive to mid caps. Merger & acquisition activity continues to be robust with larger companies starved for growth taking advantage of low financing costs to target faster growing mid cap companies. Mid caps are also well positioned for an eventual rise in interest rates. ClearBridge research indicates mid cap returns have been inversely correlated to interest rates and that mid caps have delivered higher excess returns than large caps in rate tightening periods

About Brian Angerame

A Managing Director and Portfolio Manager with ClearBridge Investments, Brian Angerame co-manages the firm's Mid Cap Core, Mid Cap Growth and Small-Mid Cap Growth products. He has more than 21 year of investment industry experience. Mr. Angerame joined a ClearBridge Investments predecessor organization in 2000 as an equity research analyst, responsible for the consumer discretionary and consumer staples sectors. Previously, he was an analyst and assistant portfolio manager of the Prudential Real Estate Securities Fund at Prudential Investment Management. A member of the New York Society of Security Analysts, Mr. Angerame earned his B.A. in government from Dartmouth College.

About Derek Deutsch, CFA

A Managing Director and Portfolio Manager with ClearBridge Investments, Derek Deutsch co-manages the firm's Mid Cap Core, Mid Cap Growth and Small-Mid Cap Growth products. He has more than 16 years of investment industry experience. He joined a ClearBridge Investments predecessor organization in 1999, spending six years as an equity research analyst responsible for the health care sector. Previously, Mr. Deutsch was a special assistant at the U.S. Department of Health and Human Services in Washington, D.C., and also worked as a journalist covering health care policy for the American Political Network. A Chartered Financial Analyst, he is a member of the CFA Institute and the New York Society of Security Analysts. Mr. Deutsch earned a B.A. from Brown University and an M.B.A. from Georgetown University.

About ClearBridge Investments

ClearBridge Investments is a well-established global investment manager with $103.9 billion in assets under management as of September 30, 2015. With a legacy dating back over 50 years, the firm's long-tenured portfolio managers and fundamental research team focus on building equity portfolios for clients who seek income, high active share or low volatility solutions. Owned by Legg Mason, ClearBridge Investments operates with investment independence from headquarters in New York and offices in Baltimore, San Francisco and Wilmington.

About Legg Mason

Legg Mason is a global asset management firm with $697 billion in assets under management as of September 30, 2015. The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM).

All investments involve risk, including loss of principal. Past performance is no guarantee of future results. Mid-cap stocks involve greater risks and volatility than large-cap stocks.

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S. Please note an investor cannot invest directly in an index.

The S&P MidCap 400 Index is a market-value weighted index which consists of 400 domestic stocks chosen for market size, liquidity, and industry group representation. An investor cannot invest directly in an index.   

S&P 500 High Quality Rankings are designed for exposure to constituents of the S&P 500 identified as high quality stocks. S&P 500 Low Quality Rankings are designed for exposure to constituents of the S&P 500 identified as low quality stocks. Quality Rankings reflect the long-term growth and stability of a company's earnings and dividends.

Sharpe ratio is a risk-adjusted measure, calculated using standard deviation and excess return to determine reward per unit of risk. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.

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SOURCE ClearBridge Investments