By Richard Diennor Mid-cap stocks and mutual funds that invest in them have been on a roll so far this year, but the winning streak may soon come to an end. Through October, stocks of midsize companies had performed better than those of small and large ones, as measured by gauges compiled by Standard & Poor's. The S&P MidCap 400 index rose 5.6% during that span, while the S&P 500 and the SmallCap 600 indexes climbed 1.1% and 3.1%, respectively.
Similarly, mid-cap funds topped all other fund categories through the first 10 months of the year. In the mid-cap category, blend funds gained 3.9%, growth portfolios climbed 3.6%, and value ones rose 3.1%. By comparison, the average domestic equity fund returned 2%.
MATURITY FACTOR. Investments in mid-cap funds increased to $36 billion last year, from $25.2 billion in 2003 and $14.9 billion a year earlier, according to Financial Research Corp. The funds attracted $22.3 billion this year through Sept. 30.
However, a number of market watchers think investors will begin moving into big companies some time next year if interest rates and inflation rise and the U.S. economy slows. In that kind of environment, investors will prefer the stability and maturity that large businesses can offer, they say.
Also, relatively small companies may be hurt by tightened monetary policy because they're more apt to carry long-term debt and, therefore, worse off if they need to borrow, says Kenneth Shea, director of global equity research at Standard & Poor's. "I think you're going to see money rotating toward the S&P 500 and large-caps," Shea says. "I think interest rates are going to be the biggest catalyst to get them there."
PROVEN RECORDS. In the same vein, Sam Stovall, chief investment strategist for Standard & Poor's, thinks mid-caps cannot outperform other stock categories for much longer. "I think they must be in the eighth inning or so by now," he says.
Shea notes that investors have been embracing small companies and mid-caps over the last few years mainly because of their willingness to accept risk to gain higher returns. The rise of mid-caps may have signified that people would still go out on a limb, but not as far as before, he says.
In general, stock pickers point out that midsize companies can grow as quickly as small ones and faster than big ones. Unlike small companies, midsize outfits also tend to have established products and proven track records of generating earnings. The last two attributes can make midsize companies "prime" candidates to be acquired by big ones, Stovall says.
ACCESSIBLE BIGWIGS. James Lloyd, senior analyst with the Leuthold Group, which provides market research, says mid-cap stocks tend to hold up better than small-caps in down markets. "When the world starts to go in the wrong direction, the small-cap action can turn pretty ugly, and mid-caps are maybe a little safer bet," Lloyd says.
David Kelley, co-manager of the $1.4 billion RS Investment Trust:Value Fund (RSVAX), says one reason he likes midsize companies is that their top executives make themselves accessible -- not always the case with big businesses.
Kelley's fund, ranked 5 Stars by Standard & Poor's, distinguished itself as one of the best performing mid-cap value funds for the three and five years ended last month. It returned 32.8% and 16.2%, respectively, in those periods, while its peers rose 20.5% and 8.8%, on average.
HOT COALS? One stock Kelley likes is Regis Corp. (RGS), which operates and franchises hair salons, including the Jean Louis David and Supercuts chains. The company also runs schools that train stylists. It features a stable revenue stream and solid and improving returns on invested capital, Kelley says. He figures Regis can increase its free cash flow by at least 10% annually for the next three to five years.
Another favorite of Kelley's, MI Developments (MIM), deals in commercial and industrial real estate. MI generates free cash flow and, unlike similar companies, has very little debt on its balance sheet, the fund manager says.
Leslie Globits, co-manager of the $207 million Victory Special Value Fund (SSVSX), says the fund began buying energy and related stocks in mid-2004. Its holdings in the sector include a pair of coal-mining companies, Peabody Energy (BTU) and Arch Coal (ACI), which Globits sees benefiting from increasing demand for coal from utilities.
ALREADY PEAKED. Victory Special Value, ranked 4 Stars by Standard & Poor's, generated the second-best returns among mid-cap value funds for the one-year period ending last month, gaining 24%, compared with 14% for its peers.
While it's difficult to tell when large-caps will come back into vogue, it appears mid-caps have already had their day in the sun.
Diennor is an reporter for Standard & Poor's Fund Advisor