Mid-Caps: The Undiscovered Country
Investors debate the relative merits of large-cap vs. small-cap stocks with the relish that baseball fans compare Joe DiMaggio and Ted Williams, oenophiles various vintages of Bordeaux, and classical music lovers the best recordings of Beethoven's piano sonatas. This year is no exception, especially following the heady gains of the S&P 500 and S&P SmallCap 600 over the past one- and three-year periods.
For each asset class there are many arguments pro and con. But S&P Equity Strategy recommends that market participants take a good look at the mid-caps - those companies with market capitalizations of $1 billion to $4.5 billion. In addition to very competitive long-term returns, the S&P MidCap 400 index was up 0.8% this year through January 18 vs. a 0.6% gain for the S&P 500 and a 0.9% decline for the S&P SmallCap 600.
We think mid-caps represent the "sweet spot" of the U.S. equity market. Earnings growth is faster than among the large-caps, while volatility is lower, and valuations are more attractive than those of small-caps. In addition, while most institutional and retail investors already have sizable allocations in the large- and small-cap asset classes, mid-caps remain largely undiscovered, paving the way for strong money flows as this asset class draws greater investor interest.
The macroeconomic environment also favors mid-caps. Amid a slowing economy and concern about decelerating earnings, investors are likely to gravitate toward asset classes with the highest potential profit growth. We expect earnings for large- and small-cap firms to slow in 2007 - to 10% from 15% in 2006 for large-caps and to 10% from 14% for small-caps. But we see the S&P MidCap 400 posting 16% profit growth this year vs. 15% in 2006.
Mid-cap valuations look good too. S&P Equity Strategy's favorite metric is the p-e-to-growth ratio, obtained by dividing the p-e by the projected earnings growth rate. A lower ratio reflects better relative value. While the S&P 500 index trades at a p-e-to-growth ratio of 1.5 times 2007 estimates and the S&P SmallCap 600 index trades at 1.7, the S&P 400's p-e-to-growth ratio is only 1.
In conclusion, we believe equity investors can benefit from a domestic mid-cap allocation. Mid-cap stocks represent 4% of the 40% domestic equity weighting in our current global asset allocation, equating to 10% of the overall U.S. equity allocation. But growth-oriented investors who seek long-term capital appreciation, and have time horizons of three years or more, should consider increasing their exposure to as much as 20%.