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Midcap stocks have been called the "equities sweet spot". Is this justifiable? In a word, it is.

Based on the data available, midcap stocks have performed much better over the years than large cap or small cap stocks. However, now, there are at least six different measures of what constitutes a U.S. midcap stock. Which of these measures centers on the perceived sweet spot? If midcap companies are advantaged overall, why are they advantaged?

Midcap Stock Indexes

Below are six U.S. midcap stock indexes. Each of these indexes tracks a different number of stocks and stocks of a somewhat different average market capitalization. The listing is in approximate, if not exact, average market capitalization order.

Index

Target Stock Size by Market Cap Rank

Target Stock Size by Market Cap %

ETFs Using the Index

First Data Year

Russell

201-1,000

IWR

1983

CRSP

(Approx. 274-622)

70%-85%

VO (future)

2002

MSCI

301-750

VO (current)

1996

Morningstar

70%-90%

2000

Dow Jones

501-1,000

SCHM, EMM

2001

S&P 400

Variable

IJH, MDY, IVOO

1983

Notes:

(1) IWR is the iShares Russell Midcap ETF, VO is the Vanguard Midcap ETF, SCHM is the Schwab U.S. Midcap ETF, EMM is the SPDR Dow Jones Midcap ETF, IJH is the iShares Core S&P Midcap ETF, MDY is the SPDR S&P Midcap 400 ETF, and IVOO is the Vanguard S&P Midcap 400 ETF.

(2) CRSP stands for (University of Chicago Booth) Center for Research in Security Prices. Over the course of about the first half of next year (2013), Vanguard will change 22 of its funds, including VO, so they use CRSP or FTSE versus MSCI (Morgan Stanley Capital International) indexes. The transition for each fund will be done in a single day or close to it. The date(s) for each transition will be publicly unknown until the transition is completed. After completion, each transition will be publicly announced as completed. To avoid fund trading costs and bid/ask spread losses, you may not want to buy shares or additional shares of VO until the transition for VO has been announced as completed.

As you can see, the stock size numbers provided in the table above are only target numbers. In reality, the sizes of the stocks in the indexes are more diverse because the index providers have rules to limit turnover. 70%-85% in the Target Stock Size by Market Cap % field means the index is targeting stocks in the 70 to 85 percent bandwidth of the total U.S. stock market value. (In this case, large stocks constitute the top 70% of the total market value of U.S. stocks.)

The S&P (Standard & Poor's) 400 constitution is determined by somewhat flexible rules and a committee. The other midcap indexes are rules based. For initial inclusion in the S&P 400, the S&P 400 committee takes into account things like market capitalization, at least four consecutive quarters of positive GAAP earnings, and a sufficiently strong balance sheet. They also try to make the constitution of the S&P 400 match the constitution of the midcap space (as defined by S&P) from a sectors (i.e., financial, industrial, technology…) perspective. S&P's standard for continued inclusion in the S&P 400 is less strict than their standard for initial inclusion.

A key thing to notice in the table above is that the midcap indexes other than the S&P 400 target stocks with a significantly larger average market capitalization than the average market capitalization of the S&P 400. Even the average market capitalization of the Dow Jones midcap index is larger than the average market capitalization of the S&P 400. You can see this in looking at Morningstar data and by studying the constituents within the indexes.

Historical Performance

The CRSP, MSCI, Morningstar, and Dow Jones midcap indexes only have data going back to 2002 to 1996. By going to this Bogleheads webpage, you can see the 10 to 16 year performance of each of the six midcap indexes. Notice that only the Dow Jones index performed better than the S&P 400 in the 10 to 16 year timeframe.

Since there is data for the Russell and S&P midcap indexes going back to 1983, we can do a study going back 29 full years covering the S&P 500 large cap, Russell midcap, S&P 400 midcap, Russell 2000 small cap, and Wilshire microcap indexes. In this study, the Russell 2000 and Wilshire microcap indexes appear to underperform the S&P 500 by a little less than 1.5% per year. This is not significant, though, because studies with longer time frames indicate the performance of small cap and microcap stocks is similar to that of large cap stocks. Also in this study, the S&P 400 appears to outperform the S&P 500 by 2.53% per year; and this difference seems to reflect that midcap companies are competing with an advantage. (I will write more about this later.)

The below compound annual growth rate percentages are total return figures, so dividends are included. The figures were calculated using data from the Bogleheads website, although I changed the 1990 number for the Russell 2000, as it was incorrect. (I validated the accuracy of all of the data used as best I could.)

Years

S&P 500

Russell Midcap

S&P 400

Russell 2000

Wilshire Microcap

1983-2011

10.70%

11.91%

13.23%

9.33%

9.21%

The performance differences are more striking when viewed as cumulative total returns.

Years

S&P 500

Russell Midcap

S&P 400

Russell 2000

Wilshire Microcap

1983-2011

1,805%

2,512%

3,576%

1,229%

1,188%

Notice that the Russell midcap index did not perform as well as the S&P 400 index during the time period. The CRSP, MSCI, and Morningstar midcap indexes more closely resemble the Russell midcap index. The Dow Jones midcap index more closely resembles the S&P 400 index. The data indicates that the S&P 400 and/or the Dow Jones midcap index are centered or nearly centered in the sweet spot.

The fact that small cap and microcap stocks did not perform as well as the S&P 500 during the time period is a positive for midcap stocks. It indicates that midcap performance relative to S&P 500 performance was not positively influenced by smaller stocks doing better than larger stocks during the time period. In fact, midcap stocks appear to have been disadvantaged versus the S&P 500 during the time period; so the Russell midcap and S&P 400 versus S&P 500 results were probably lower than they normally would have been.

So far (i.e., as of December 14) in 2012, midcap stocks have generally outperformed large cap and small cap stocks.

Why the Better Performance?

I worked in about 25 different organizations and worked with many more. These organizations varied in size from just a few people to some of the largest companies in the world. There are advantages and disadvantages in being a small company, and advantages and disadvantages in being a large company. Describing these advantages and disadvantages is a very long endeavor. Smaller companies are more nimble. Larger companies have more social and political clout. Smaller companies do not have to spend as much time on internal coordination. Larger companies have greater economy of scale. Etc. Once a company becomes large enough, though, there are some unique disadvantages; and these are disadvantages that investors and analysts very often do not account for in determining the fair price for a stock.

(The differences between large, medium, and small companies are usually not important in determining which stock size is, generally, a better purchase, if any. The differences between large, medium, and small companies that investors and analysts do not or inadequately account for are important.)

(1) Large companies are much more limited by regulation in regard to whom they can acquire. Even if an acquisition is approved, the company may have to sell some of the assets of the company being acquired. Sometimes, a large company spots a deal that would benefit its shareholders; but it cannot execute, or fully execute, the deal. Regulators do not want the company to be too dominant in a certain business area(s), regardless of whether the company would have a monopoly. There are acquisitions large companies would make if they could make them, but they never seriously consider the acquisition because they know the deal will not be approved. Investors and analysts strongly tend to not factor in the value of potential acquisitions less news regarding a specific potential acquisition; and, when there is news regarding a specific potential acquisition, they strongly tend to only factor in the value of the specific acquisition for which there was news.

(2) Large companies can be too large to be acquired. Acquisitions occur at relatively attractive prices. The acquisition of companies in a stock index improves the performance of the stock index.

(3) Sometimes, large companies need to adhere to special rules related to their size. The limits on Microsoft (NASDAQ:MSFT) due to the dominance of its PC operating software are an example of this. Google (NASDAQ:GOOG) has similar issues related to the dominance of its search engine in many markets. The bank capital rules that have arisen since the financial crisis are another example. In the future, large banks will need to have a higher percentage of capital available as protection. This places these banks at a competitive disadvantage. The higher protection capital requirement was set because large banks are, at least somewhat, "to big to fail". Investors and analysts strongly tend to not factor in these things that occur to large companies until news breaks regarding a specific rule(s).

This explains why the outperformance of midcaps versus large caps may not be an anomaly, but instead a reality; but why would midcaps outperform small caps?

(1) Business competition is not as fair as many people think it is. Larger companies do things like overspend or under price in a certain niche to crush a smaller company, if the smaller company will not agree to be purchased at a good (for the larger company) price. The larger company may not even offer to buy the smaller company and, instead, simply crush it. (A company needs to be larger to pull this sort of thing off. [You can sustain a loss in just a certain part of your operations for a while.]) Investors and analysts tend to not account for this sort of thing until a specific incident occurs.

(2) Midcaps generally have greater political clout than small caps; and this is very often not factored in by investors and analysts until a specific related incident occurs. For example, a midcap company is more likely to get special considerations (e.g., reduced taxes) for locating an operation in a certain country, state, or city.

(3) Midcaps, versus small caps, are more likely to be as they represent themselves to be. Midcap companies have been and are better-covered by analysts and the media.

In any event, based on performance statistics by stock size, it appears it is generally better to be big, but not too big.

Conclusion

Statistics show that midcap stocks significantly outperformed other stocks over the course of the last 30 years. This historical outperformance by midcap stocks could be an anomaly; but I do not think it is, or entirely is, because it seems that large and small companies are playing the stock price game at a disadvantage. Large companies have unique disadvantages in that their ability to acquire other companies is limited, their ability to be acquired is limited or non-existent, and, sometimes, they need to adhere to special rules. Small companies are disadvantaged by their lesser resources to play the game rough and lesser political clout. Also, they are riskier in that they were not and are not as well-covered by analysts and the media. These disadvantages are under accounted for by investors and analysts in determining the fair price for a stock.

Based on the last 30 years of data, the midcap stocks sweet spot is centered at or near the S&P 400 index and/or Dow Jones midcap index. The Morningstar, MSCI, CRSP, and Russell indexes are somewhat off center, with, it seems, the Russell index being the most off center, the CRSP index less so, the MSCI index even less so, and the Morningstar index even more less so.

I think it is advisable to invest in the S&P 400 and/or Dow Jones midcap index versus investing in other multi-sector U.S. stock indexes via funds like iShares S&P 100 Index Fund (NYSEARCA:OEF), SPDR S&P 500 ETF (NYSEARCA:SPY), iShares Core S&P 500 ETF (NYSEARCA:IVV), iShares Russell 1000 Index Fund (NYSEARCA:IWB), Vanguard S&P 500 ETF (NYSEARCA:VOO), iShares Russell 2000 Index Fund (NYSEARCA:IWM), iShares Core S&P Small Cap ETF (NYSEARCA:IJR), or Vanguard Small Cap ETF (NYSEARCA:VB). (It should be noted that VB targets stocks ranked by market capitalization from 751 to 2,500. VB significantly overlaps the S&P 400 and Dow Jones midcap indexes. This being the case, VB may be a better investment than the other ETFs listed immediately above.) Taking a more conservative approach, investors can overweight the S&P 400 and/or Dow Jones midcap index versus simply investing in a multi-sector, multi-stock-size U.S. stock index via funds like Vanguard Total (U.S.) Stock Market ETF (NYSEARCA:VTI) or iShares Russell 3000 Index Fund (NYSEARCA:IWV).

Source: Locating The Mid Cap Sweet Spot - And Understanding Why It Works