5 Reasons Investors Should Own More Mid-Cap Stocks

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Includes: COTY, FMC, MJN, OLN, PDCO, TPR
by: Willow Street Investments

Summary

Large-cap stocks tend to offer more limited share-price growth prospects given that their best years of growth are long past them.

Mid-cap stocks can offer greater share price appreciation potential and can counterbalance an overly conservative stock portfolio with less risk than small-cap stocks.

Mid-cap stocks receive less financial media coverage, but are more readily able to transform than large-cap stocks and also offer greater growth potential.

An investor increasing their exposure to mid-cap stocks also increases their exposure to stocks having greater potential to be a takeover target.

We focus on investing in out of favor mid-cap dividend stocks facing transformation uncertainties with multiple insider purchases and recommend investors do the same.

When we first started out investing in the mid 1990s, we tended to choose mostly large capitalization stocks such as Coca-Cola (NYSE:KO), General Electric (NYSE:GE), Intel (NASDAQ:INTC) and Merck (NYSE:MRK). We learned over time, however, that while such stocks provided relative stability and mostly moderate dividend growth, we found that the growth prospects of the shares of such stocks were largely long behind them. The share price of most of these large capitalization companies has about doubled in the two decades since we owned them. Such share price performance is not exactly awe inspiring, and, if a portfolio has too many of these stocks in it an investor may underperform over the long term. With this in mind, in recent years we have gained a much greater appreciation for middle capitalization ("mid cap") stocks given the benefits such stocks offer to an investor's portfolio. Not only can mid cap stocks offer superior investment returns, an investor should also hold such stocks as a strategy to mitigate risk in a well-diversified portfolio. In particular. an investor should hold a combination of small, middle and large capitalization stocks. Smaller capitalization stocks offer the greatest growth potential, but such growth involves the most risk. On the other end of the spectrum, large capitalization stocks offer the greatest stability, but such stability comes with the lowest growth prospects. Mid-cap stocks. however, offer benefits of both small and large capitalization stocks.

The benefits that mid-cap stocks provide to investors include a balance between growth prospects and stability. Although the definition of mid-cap stocks has changed over the years along with the other categories, investors today consider a mid-cap stock to have a market capitalization of between $2 billion and $10 billion. (For the purposes of this article and our mid-cap investment philosophy we tend to stretch the mid-cap definition to about $1.5 billion to about $20 billion. In other words, the "mid cap" stocks we prefer to invest in stray slightly from the strict mid-cap definition but have a significantly lower market capitalization than large capitalization stocks.) In recent years, we have focused on out of favor mid-cap dividend stocks that meet one or more of the criteria: 1) a dividend yield of at least 2.0 to 2.5 percent with or without growth in such dividend (or a dividend yield of 1.5 to 2.0 percent where there is at least moderate dividend growth); 2) the stock was a spin-off stock from a larger capitalization company whereby the business spun-off was previously neglected but shows potential; 3) the shares of the company are trading within 5 to 10 percent of a 52-week low; 4) the company is the subject of investor uncertainty from transformative activities including a significant acquisition; and 5) multiple insiders have purchased the shares of the company near 52-week lows. These criteria have served us well in recent years by providing us with solid investment picks (some of which we invested in and some we did not).

Some of the mid-cap stocks we have purchased (or considered purchasing) in recent years that have provided outsized returns include: 1) Chemours (NYSE:CC) - a neglected spin-off that faced transformation and litigation uncertainties; 2) FMC Corporation (NYSE:FMC) - which faced transformation and adverse agricultural market uncertainties; 3) Mead Johnson (NYSE:MJN) - a spin off which faced adverse market conditions but has since agreed to be acquired; and 4) Olin Corporation (NYSE:OLN) - which also faced transformation uncertainties and adverse global economic conditions. Other mid-cap stocks we have purchased but have yet to provide desired returns but continue to offer potential positive investment outcomes include: 1) Coach, Inc. (COH) - a company that diminished its brand but is now successfully turning around; and 2) Patterson Companies (NASDAQ:PDCO) - a company that has undergone a significant transformation to focus more sharply on animal health and dental markets. Our latest pick is Coty, Inc. (NYSE:COTY) - a company that has made a significant acquisition to achieve retail scale and cost synergy opportunities that has also created investor uncertainty due to near-term integration adversities. There are several reasons why we are increasing the number of mid-cap stocks we hold in our portfolio. With this in mind, we offer the five most significant reasons investors should own more mid-cap stocks.

1) Mid-cap stocks offer greater growth potential:

As noted above, mid-cap stock investment risk falls between small-cap stocks and large-cap stocks. An overly conservative portfolio filled almost exclusively with large-cap stocks offers stability but lacks growth. An overly risky portfolio consisting of mostly smaller cap stocks offers the most significant growth potential, but leaves an investor facing the highest risk. The middle ground between such choices, however, is mid cap stocks that offer the most appropriate balance between growth and risk for an investor seeking to transform their portfolio towards greater growth opportunities. These days we favor adding two mid-cap stocks to our portfolio for every large-cap stock we add. By rebalancing our portfolio towards mid-cap dividend stocks with greater share price growth possibilities, we increase the growth opportunities of our overall portfolio. (Remember, back in 1996 when we first started investing more seriously, we purchased the shares of the then mid-cap Apple, Inc. (NASDAQ:AAPL) and we know how that story turned out. The time to invest in AAPL shares for share price growth was back then, but not now given the law of large numbers makes it much more difficult for the company to offer share price growth.)

2) Mid-cap stocks tend to trade under the radar:

While analysts provide some coverage to mid-cap stocks, the financial media tends to ignore such stocks until they are involved in a major event. For example, we purchased FMC shares three times in 2014-15 as the company was transforming to navigate severely adverse agricultural conditions. During the time period of our share purchases, the company's transformative efforts were largely ignored by the mainstream financial media, which tends to cover the same handful of high-profile glamour stocks on a daily basis. Fast forward a couple of years and FMC is further along in its transformation and has announced a major acquisition while it is also rumored to be a takeover target itself. (FMC shares, as a result, have surged higher.) What a difference a year or so makes for investors in a mid-cap company in transformation. With this in mind, investors need to search beyond the daily financial headlines to comb through mid-cap stock opportunities for companies that tend to receive far less media coverage. In our experience, the greatest investment rewards are frequently in less covered mid-cap stocks.

3) Mid-cap stocks are able to transform more readily:

As a long-suffering investor in GE shares, we understand that an investor in a large-cap stock can wait several years for a transformation designed to drive shares higher to actually achieve such desired results. Mid-cap stocks, however, can be more nimble in their transformation efforts. In addition, transformative new product offerings and acquisitions/divestitures can more quickly and readily drive revenue/earnings growth for a mid-cap stock given that such stock has a smaller revenue/earnings base to build upon than a large-cap stock. In other words, the law of large numbers makes it harder to "move the needle" with respect to a large-cap stock when compared to a mid-cap stock. Although this idea seems obvious, we believe investors tend to gloss over this idea when searching for growth opportunities. A company such as AAPL, with all of its past successes, will have a more difficult time transforming to positively effect its revenue/earnings growth given its large revenue/earnings base. A mid-cap stock, however, offers investors a smaller revenue/earnings base from which a company can transform and grow from, thereby offering greater share price appreciation potential. These days, this is where we want to be and where we believe many other investors should also be.

4) Mid-cap stocks are more likely to be takeover targets:

Although we believe that investors should invest in mid-cap stocks for their intermediate and long-term operational prospects, there is also the bonus investment opportunity that mid-cap stocks are more likely to be takeover targets over the intermediate and long term. No informed investor can ever expect to see an acquisition of KO, GE or INTC, but a mid-cap stock is another story. For example, we purchased MJN shares as noted above with the idea that the company was a takeover target over the long term. We did not purchase the company's shares expecting an imminent takeover, but just a few months after our late 2016 share purchase the company agreed to be acquired. Other stocks noted above that we also hold shares in and continue to be takeover targets include COH, COTY, FMC and PDCO. Of course, there many mid-cap stocks beyond those we have identified here that are likely takeover targets which investors should seek out and consider investing in. With this in mind, investors should broaden their investment perspective to add more mid-cap stocks to their portfolio not only for their growth prospects but also their takeover prospects.

5) Mid-cap stocks counterbalance an overly conservative portfolio:

Investors should also consider adding mid-cap stocks to their portfolio to counterbalance an overly conservative group of stocks. For many of the reasons discussed above, mid-cap stocks offer increased returns with an amount of risk that falls between small-cap and large-cap stocks. As we noted above, when we first started building our portfolio a couple decades ago we focused far too much on large-cap stocks whose growth was long past. Of course, there is nothing wrong with holding some large-cap stocks in any stock portfolio. The problem arises when an investor holds too many large-cap stocks without any counterbalancing growth opportunities. For us, mid-cap stocks with a sizeable dividend and growth opportunities provide the greatest potential any investor can hope for. That potential includes: 1) dividends to reinvest; 2) dividends with the potential to grow; and 3) a greater opportunity for share price appreciation. A mid-cap stock that includes these possibilities in our mind is where we want to be these days when searching for new investment opportunities. While we hold shares in a company such as GE, we want to move further away from investing in any more large-cap companies where dividend growth is at a near standstill and share price growth is practically nonexistent. A long-suffering GE investor will know what we mean and why we are seeking out and investing in more mid-cap stocks to drive portfolio growth.

Our View

We wish we began investing in mid-cap stocks earlier than just the last several years, but we believe that our investing horizon is sufficiently long that we would be foolish not to move further into the mid-cap stock category. As noted above, our latest mid-cap purchase was COTY. (Our prior purchase, MJN, turned out to be a magnificent call given its acquisition months after our purchase.) The younger an investor is the more strongly they should consider increasing the number of mid-cap stocks that they hold for the long term. As noted above, the mid-cap stocks we favor are out of favor dividend stocks experiencing multiple insider purchases given our observation that such fact pattern offers the greatest investment return potential. With this in mind, investors should go forth and invest in more mid-cap stocks to capture growth opportunities without the increased risk of small-cap stocks.

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Disclosure: I am/we are long FMC, COH, KO, INTC, GE, COTY, MJN, MRK, PDCO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.