This article will explain what ‘mid-cap stocks’ are and why investing in them can be advantageous.
What does it mean?
Before we get to the stocks portion, we must first define what the ‘mid-cap’ is. This is a term that applies to companies possessing a market capitalization that is between $2 billion and $10 billion. In the most rudimentary sense, mid-cap stocks inhabit a piece of the stock market that tends to be forgotten.
Drawing from the implications that the name brings, a mid-cap company falls in the middle of the pack. Specifically, that which exists between large-cap (alternatively big-cap) companies and small-cap companies. Categorizations like large-cap, mid-cap, and small-cap are, in actuality, only approximations; they may change as time goes by.
For the purpose of elaboration, large-cap stocks refers to a company with a market capitalization value of more than $10 billion. Small-cap, on the other hand, classifies companies with relatively small market capitalization. Large-cap is short for “large market capitalization,” and likewise, short-cap is short for “short market capitalization.”
The definition is – by all accounts – arbitrary. However, mid-caps are not typically large enough to garner universal recognition. Be that as it may, it does not mean that they don’t have plenty of room to grow.
Overall, you can view mid-caps as something of a sweet spot for discerning investors. Particularly, for those looking for opportunities for higher growth without the high risks that can come with it.
Debt & Equity
There are two notable methods in which a company can raise capital when they need to. They can do it either through debt or equity.
As one might easily guess, the debt must be paid back. However, it is possible for someone to borrow it at a much lower rate than equity. This is primarily due to tax advantages. While equity costs more, it does not necessarily have to be paid back; especially not during times of crisis.
Because of this, the chief goal of most companies is to strike a balance between debt and equity. This specific balance is what is commonly referred to as a firm’s ‘capital structure’. Capital structure, especially equity capital structure, can effectively inform investors about the growth expectations of a company. It can often be an amalgamation of a firm’s debt and equity. To elaborate, it’s often a melding of long-term debt, short-term debt, common equity, and preferred equity.
‘Market capitalization’ is the total dollar market value of a company’s outstanding shares. The investment community uses this number to establish the size of a company.
One way to get a rough idea about a company’s capital structure and market depth is by computing its market capitalization. Companies possessing low market capitalization (small-caps) usually have up to $2 billion or less in market capitalization. Large-capitalization firms have over $10 billion in market capitalization. The remaining mid-cap firms exist in between $2 billion and $10 billion.
There are additional categories that exist alongside the three we have been discussing. Their inclusion is primarily for the sake of context. These categories include:
- Mega-cap – market capitalization is over $200 billion
- Micro-cap – market capitalization is $50 million to $500 million
- Nano-cap – market capitalization is less than $50 million
Mid-caps have an appealing feature that attracts investors to them. It’s the fact that there is an expectation for them to grow and increase profits, market share, and productivity. This is what places them directly in the middle of their growth curve.
A popular idea is that they are in a growth stage, therefore they are seen as less risky than small-cap. However, they are also viewed as being more risky than large-caps. Mid-cap companies experiencing success often run the risk of having their market capitalization go through a rise. This is due to an increase in their share prices. It gets to a point where they are no longer suitable for the ‘mid-cap’ category.
Market capitalization depends heavily on market price. Regardless of that, a company with a stock price of over $10 is not automatically a mid-cap stock. In order to calculate market capitalization, analysts need to multiply the current market price by the current number of shares outstanding.
Reasons for inclusion
Generally speaking, the performance of mid-cap stocks is equal to – or sometimes better than large-cap and small-cap stocks. Thus, it’s important to remember that solid performance is not the only reason to include mid-caps in a portfolio. There are a host of other reasons that make it appealing.
For starters, a majority of mid-caps are basically just small-caps that are now bigger. Extra growth creates stepping stones towards the transformation to a large-cap business. A substantial part of that growth is acquiring additional financing as a means to fuel the expansion. Mid-caps typically have a much easier time of it than small-caps tend to.
Mid-caps have a notable advantage over small-caps, specifically when it comes to raising funds. Their advantage over large-caps essentially boils down to the growth of their earnings. They are comparatively smaller in size, so most of the time they have yet to reach the ‘mature stage’. This stage is where earnings slow and dividends transform into a much bigger portion of a stock’s total return. Mature industries are those that pass the emerging and growth phases of industry development.
Probably the most overlooked reason for mid-cap investment is that they garner less analyst coverage than large-caps. Historically, the best-performing stocks were companies receiving little attention and then suddenly gaining adoration. They then produce the institutional buyers that are vital for increasing their price. Some refer to this as the “money flow,” though it goes by several names. Regardless, institutional support is crucial for raising the stock price. These prominent players are able to create and destroy value for shareholders.
All in all, the choice to invest in mid-caps holds a lot of merit. They basically provide investors with advantages from both sides: small-cap growth blending with large-cap stability.
The profitability of it all
A great thing about mid-cap stocks is that you are essentially investing in businesses that are generally profitable. Moreover, they have been making a good profit for some time and retain competent management teams. That being said, it does not mean their expansion has come to a close. Far from it. In actuality, the average earnings of a mid-cap often grow at a quicker rate than the average small-cap. Not only that, but it does so with less volatility and certainly a lot less risk.
In addition to growth in earnings, it is very important to find stocks whose earnings are sure to be viable in the coming years. This, above all else, is what makes a mid-cap turn into a large-cap.
There are clear-cut signs that are indicative of whether or not a company’s earnings are heading in the right direction. These include higher gross margins and operating margins that combine with lower inventories and accounts receivable. For context, ‘accounts receivable’ is the balance of money due to a firm for the delivery or use of goods or services. However, they have yet to be paid for by customers. Alternatively, accounts receivable are amounts of money that customers owe to another entity for the delivery or use of goods or services. Specifically, on credit, though clients have yet to pay for them.
Should the company consistently turn its inventory and receivables at a faster rate, then this will result in higher cash flow. Along with that higher cash flow is an increase in profits. All of these features together assist in risk reduction. Mid-cap stocks are prone to having these attributes more than any other stock time and time again.
The health of finances
Whatever the size of the stock you are showing interest in, it may be wise to invest in companies containing strong balance sheets. Benjamin Graham, a famous investor, and economist, had three principles that helped him evaluate a company’s financial health:
- Total debt comes out to being less than tangible book value. An asset’s book value equates to its carrying value existing on the balance sheet. The formal definition of tangible book value is total assets less goodwill, other intangible assets, and all liabilities.
- A current ratio that is greater than two. ‘Current ratio’ is a liquidity ratio that calculates a company’s capability of paying short-term obligations. Alternatively, those that are due within one year. Another definition is current assets that are divided by current burdens.
- Total debt is less than two times the net current asset value. Companies that meet this criterion can pay off their debts with cash and other current assets. This effectively makes them far more stable in the eyes of investors.
Business is, on the whole, very unpredictable. A strong balance sheet can mitigate this uncertainty and help companies get through the lean years. Due to mid-caps often having stronger balance sheets than small-caps, this diminishes risk. At the same time, it may provides superior returns to those concerning large-caps.
When it comes to mid-cap investments, you are, in a way, combining two things. One is the financial strength of a large-cap and the other is the general growth potential of a small-cap. The outcome of this amalgamation is typically above-average returns.
Aiming for growth
The growth of revenue and earnings are undoubtedly two of the most significant factors in long-term returns. Recently, there have been instances of mid-cap stocks outperforming large-cap and small-cap stocks alike. This is mostly due to their superior growth on both the top and bottom lines. Many industry experts believe that mid-caps are capable of producing better returns because they act swifter than large-caps. Furthermore, they are more financially stable than small-caps. As a whole, they provide double the benefits in the pursuit of growth.
Investors that show interest in mid-cap stocks should take the revenue growth quality into consideration when they are investing. Is there is a noticeable increase in gross and operating margins at the same time as revenues? If so, then it is a clear indication that the company is developing better economies of scale. This will eventually result in considerably higher profits for shareholders. An additional sign of healthy growth in revenue is a lower debt total, as well as higher free cash flow.
The list of growth signs is extensive. Many of the criteria investors employ as a way to assess stocks of any size applies here. However, it is crucial when it comes to mid-caps that you see progress on the earnings front. This largely because that is what is going to eventually transform it into a large-cap. Revenue growth is important, that much is obvious, but earnings growth is just as essential.
When purchasing stocks, no one wants to overpay. Warren Buffett is of the belief that:
“It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
It’s common to refer to people showing interest in growth at a reasonable price as GARP (Growth at a Reasonable Price) investors. There are certain things that GARP investors focus on when it comes to evaluating mid-cap stocks. These include growth measures, like sales, and earnings growth rates. Moreover, value measures like price/earnings and price/cash flow. Regardless of the measures you choose to utilize, the most important criteria should always be the company’s overall quality.
Why they are attractive
It is not possible for anyone to tell when the market will support or favor a specific kind of company. This is regardless if it is a large-cap, mid-cap, or small-cap. With this in mind, it is important to diversify your portfolio. However, the percentage of mid-caps that you wish to invest in depends entirely on your personal goals and risk tolerance. In this sense, the choice and practice are both completely subjective.
Below are a handful of reasons as to why investors may consider mid-caps as an investment. This list may also function as a recap of what we have learned.
- Corporate growth is stable whenever interest rates are low and capital is less costly. Mid-cap companies are able to obtain the credit they need in order to grow. Moreover, they do very well during the expansion portion of the business cycle.
- A majority of mid-caps are widely recognized and their focus is often on one particular business. Not only that, but they have existed long enough to create a niche in their target market.
- Mid-caps do not pose as much of a risk as small-cap companies. What this means is that they usually do well financially in the midst of economic instability.
- Because mid-caps are comparatively riskier than large-caps, they potentially have a higher return. This, of course, could be more of an appealing option to a less cautious investor and their bottom line.
Investors are able to either purchase a mid-cap company’s stock directly or buy a mid-cap mutual fund. This is an investment vehicle that focuses primarily on mid-cap companies. They consist of a pool of money collected from numerous investors as a way to invest in securities. These include such things as stocks, bonds, money market instruments, and various other assets.
Investing in mid-caps is a common method for simultaneously diversifying and enhancing an investment portfolio’s performance. However, it might not be suitable for everyone.
There are some investors out there who may find that there is too much work in the evaluation of individual stocks. Are you this kind of investor? If so, fear not because there is an alternative. You can invest in exchange-traded funds (ETFs) or mutual funds, leaving the evaluation process to the professionals.