Mid-Caps: Little Respect, Lots of Potential

History teaches that middle-of-the-road stocks lead the way in a recovering economy -- a lesson that seems to be repeating itself

If you're scouting underappreciated investments, cast an eye on mid-cap stocks. Lately, they've been quietly outperforming their large-cap brethren. And while lots of investors continue to buy large-cap stocks for their stability and small-cap stocks for growth, these middle-of-the-road stocks (market capitalizations between $1 billion and $10 billion) are expected to continue to outperform.

The numbers are already telling. Since its 52-week low in March, the Standard & Poor's Mid-Cap 400 index has gained about 21%, easily outpacing the Large-Cap S&P 500's 14% gain. So far this year, the disparity is even greater, with mid-caps up 1.43%, vs. a 4.88% decline for the S&P 500.

And investors have begun to take notice. Mid-cap mutual funds saw inflows of $3.4 billion in April, according to Lipper Inc., up from only about $800 million and $300 million in February and March, respectively. (Lipper hasn't yet compiled data for May.)

Analysts expect mid-caps to outperform their larger counterparts on the earnings front as well. Thomson Financial/First Call forecasts an earnings gain for the S&P Mid-Cap 400 of 2.4% this year, compared with a projected decline of 4.5% for the S&P 500. For the first quarter of the year, earnings declined only 1.2% for the Mid-Cap 400, compared to the 6.2% drop suffered by the S&P 500.


  What sparked the mid-cap rally? "Everyone's scratching their heads and trying [to answer] that question," says Ron Sloan, who oversees the AIM Midcap Equity Fund (GAGTX ). "I think it's largely that they got to such relatively depressed levels vs. large-caps that they were due for a bounce." Money also is starting to flow back into beaten-down stocks generally, including mid-caps. That's especially true for tech stocks.

"They were beaten down pretty well and with [Federal Reserve Chairman Alan] Greenspan cutting rates and people getting more comfortable with owning equities, they're going to go where the growth opportunities are," says Jeff Parker, who manages the PIMCO Target Fund (PTAAX ).

The Fed has indeed helped a lot. Falling interest rates are improving liquidity, and that helps smaller companies more than others because they generally need to raise capital more often than their larger counterparts. If a turnaround in the U.S. economy is a few quarters away, as many economists believe, mid-caps have even more allure.

Jay Ritter, an analyst with Morningstar.com, points out that large-caps have historically held up better in the early stages of an economic downturn, but stocks with smaller capitalizations have led on the way back up. Also, they can be a safer bet in an uncertain climate. "If you don't know where you are, mid-caps aren't a bad bet...because they're not as volatile as small-caps but they tend to perform better when the economy's improving than the big-caps," Ritter says.

Mid-cap and small-cap stocks also tend to outperform the broader market when interest rates are falling. Through Apr. 4, the markets' low point this year, the S&P Mid-Cap 400 and S&P 500 were at roughly the same levels, down 15% to 16% from their highs. But the mid-cap advantage has shown up clearly on the rebound. From Apr. 4 through June 12, the S&P 500 rose only 13.8% -- far less than the S&P Mid-Cap 400's healthy 21% gain.


  Given all this, Parker believes mid-caps still aren't getting the respect they deserve. "Everyone is so interested and curious as to when they can go back and buy Cisco (CSCO ) and Sun (SUN ), the leaders of the last economic growth cycle, as they come out of this recent downturn," he says. "I would argue that you really want to be looking at the smaller companies that are creating new opportunities, creating new products and services that are somewhat undiscovered."

Parker's favorite mid-cap stock is IVAX Corp. (IVX ), a generic pharmaceuticals company based in south Florida, mainly because he foresees a boom in new generics as a result of patent expirations over the next five years.

Bear in mind that not all mid-caps are created equal. In the recent run-up, technology and health-care concerns accounted for much of the gains. "Anytime you get big down [moves] like we had, it's like a compressed spring," Sloan says. "The most compressed spring is the one that jumps highest, and that was technology." Sloan's favorite mid-cap stocks are H&R Block (HRB ) and Apogent Technologies (AOT ).

As a GARP (growth at a reasonable price) investor, Sloan tends to buy companies that aren't necessarily the fastest growers -- and he tries to do so on the cheap. He likes "back-door plays" on more widely held concepts, such as lab-equipment maker Apogent, which he calls a back-door play on medical and biotech R&D spending. Its products may be pedestrian, but they're necessary for biotech and pharmaceutical companies. "You can get that kind of spending exposure at a cheaper price," he points out. The stock, which has a 52-week range of $16.37 to $32 and represents 2.5% of AIM Midcap Equity's portfolio, closed June 14 at $25.05.


  Sloan likes H&R Block for its diversification and ability to leverage one business against another. He notes that the company acquired some mortgage and discount-brokerage businesses and offers tax services to clients of both, giving it "a pretty nice profile of diversified financial services."

The fund manager also notes that H&R Block is targeting higher-income clients for its tax services, which are still its bread and butter. The stock represents roughly 1.5% of his fund's holdings. "And with [the new tax law], they're going to have a nice year next spring," he predicts.

Morningstar.com's favorite mid-cap stocks include Analog Devices (ADI ), Equity Residential (EQR ), and Express Scripts (ESRX ). Ritter advises investors to stay the course with Analog Devices, even though the semiconductor industry is being battered, and other communications chipmakers have been issuing dire warnings. Ritter see the stock as a long-term investment with the potential upside outweighing the downside risk.

The strong growth prospects of Express Scripts, a Missouri-based health-care management company, also remain intact, despite the slowing economy, he contends. Morningstar.com values the stock at $125 to $130 per share, significantly more than the $106 or so it trades out now. One reason: With the boost the company is getting from its pharmacy-management services, Ritter says Express Scripts should be able to easily maintain its stellar annual earnings growth of 25% to 30%.


  The analyst also says Chicago-based Equity Residential, a real-estate investment trust, remains a solid pick, assuming the company maintains its current 6% yearly dividend payout. The company probably will be able to increase funds from operations at a 9% to 10% clip for the foreseeable future, so Ritter figures that investors likely will earn an annualized 15% return from the stock.

The message is that mid-cap stocks are a happy medium. As many investors learned the hard way recently, being big doesn't protect a company on the downside. And on the rebound mid-caps may bounce back higher.

By Alan Hughes

Edited by Thane Peterson

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