Stovall: The Case for Mid-Caps

Mid-cap stocks are expected to post better earnings growth than their larger counterpartsand may have more upside in a market recovery

Year to date through June 12, the Standard & Poor's 500-stock index fell 8.8%, with eight of its 10 sectors in negative territory. Yet the S&P MidCap 400 index declined less than 1% in the same period, with seven of its 10 sectors down on the year, with Utilities off only 0.1%. What's more, since the market's bottom on Mar. 10, the S&P MidCap 400 jumped 14.4% compared to the S&P 500's rise of 5.2%.

Why the disparity?

S&P thinks it could be for at least three reasons. First, investors realize they can get higher-octane results from the more nimble stocks in the lower-capitalization groups, as they typically outpace larger-cap issues when the equity market is on the upswing.

But the mid-caps also maintain the more defensive qualities that larger-cap multinational companies traditionally offer during challenging economic periods. While they're not multibillion-dollar behemoths, mid-cap companies often have the ability to leverage their relatively large size by entering into more favorable supply contracts. Mid-cap companies are also likely to have a greater percentage of their revenues derived from overseas operations than smaller ones, thus allowing them to benefit from the currency-conversion tailwind offered by a weak U.S. dollar.

Companies that Benefit from Rising Oil

The second reason the S&P MidCap 400 could be outperforming its larger-cap sibling is the makeup of the index itself. Even though the Financials and Information Technology sectors are among the largest across all index-cap sizes, significant disparities are found in the high-flying Materials and Utilities sectors. These two groups each represent less than 4% of the weighting of the S&P 500, but make up more than 8% of the S&P MidCap 400.

In addition, while the international integrated oil companies dominate the S&P 500 Energy sector, it's the upstream Exploration & Production companies (those that benefit most from rising oil prices) that dominate the mid-cap benchmark.

Finally, S&P equity analysts, who cover about 70% of the companies in the S&P MidCap 400 index, are projecting a 16% increase in operating earnings for the "400" in 2008, as compared with only an 8% estimate for the S&P 500. Plus, despite a higher price-to-earnings ratio on 2008 estimated earnings-per-share for the mid-cap index, the PEG (P/E-to-Growth) on 2008 estimated results is more attractive for mid-caps at a multiple of 1.0 times, vs. the 1.8 times for the "500." And based on consensus estimates for projected five-year EPS growth, the PEG is the same for both at 1.2 times. As a result, we think mid-caps will likely continue to lead the "500" in the period ahead.

Industry Momentum List Update

Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Subindustry Company Ticker S&P STARS Rank Price (6/12/08)
Coal & Consumable Fuels Peabody Energy BTU 3 $78
Construction & Engineering Fluor Corp. FLR 4 $182
Diversified Metals & Mining Freeport-McMoRan Copper FCX 3 $116
Fertilizers & Agr. Chem. Monsanto MON 4 $136
Gold Newmont Mining NEM 4 $48
HyperMarkets & Super Centers BJ's Wholesale BJ 4 $39
Industrial Gases Airgas ARG 5 $60
Integrated Oil & Gas Chevron CVX 5 $100
Oil & Gas Drilling Noble Corp. NE 5 $63
Oil & Gas Equip. & Svcs. Superior Energy SPN 5 $57
Oil & Gas E&P Swift Energy SFY 5 $60
Oil & Gas Storage & Transport. Williams Cos. WMB 4 $39
Railroads Norfolk Southern NSC 4 $64
Steel Allegheny Technologies ATI 4 $66

Source: Standard & Poor's Equity Research

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