3 Ways to Play the Strength in Mid-Caps

Here are picks for individual stocks, ETFs and a mutual fund

   
3 Ways to Play the Strength in Mid-Caps

Bespoke Investment Group ran a blog post Sept. 24 highlighting the best- and worst-performing S&P Mid-Cap 400 stocks in the quarter. That got to me to thinking about mid-cap stocks and their long-term performance. Since the introduction of S&P’s mid-cap index in 1991, it has achieved a compound annual growth rate of 10.4%, 380 basis points higher than the S&P 500.

That’s just one reason mid-cap stocks should be considered for most equity portfolios. To help with that, I’ve put together a small list of stocks, ETFs and mutual funds to help you get the job done.

Stocks

Although the mid-cap index’s largest stock by market capitalization is Vertex Pharmaceuticals (NASDAQ:VRTX) at $12.7 billion, the weighted average market cap is $4.1 billion, so I’ll pick two stocks as close as possible to that number.

My first selection is Markel (NYSE:MKL), a specialty property/casualty insurer run in a similar fashion to Berkshire Hathaway (NYSE:BRK.B), in that accumulated excess premiums, otherwise known as “float,” are invested in other noninsurance businesses, public and private.

The company’s goal is to grow its book value per share over a long period of time. In the past 10 years through 2011, that metric has risen at an annual compounded rate of 12%. Since 1990, MKL’s stock price has averaged 1.7 times book value, 42% higher than where it’s currently trading.

So far in 2012, Markel’s insurance operations have been profitable, generating a “combined ratio” (a key insurance measure of profitability) of 93% for the first six months of the year ended June 30, compared to 107% in the same period last year. Any time Markel can deliver an underwriting profit is a good thing for investors.

Markel Ventures, created in 2005, is where Markel puts its annual profits to work. Run by Tom Gaynor, Markel’s long-time chief investment officer, it recently acquired Reading Bakery Systems, a manufacturer of baking systems for cookies and crackers. Markel now has majority control of 13 businesses unrelated to insurance — hence its comparison to Berkshire. It’s as patient an investor as you’ll find.

My second selection is Williams-Sonoma (NYSE:WSM), the specialty retailer of kitchen and other home-related products. So strong is its pull that Starbucks (NASDAQ:SBUX) is launching its new Verismo System 585 premium single-cup at-home beverage maker in its stores on Sept. 28.

Williams-Sonoma lost its footing back in 2008, but has since regained its luster and then some. In the second quarter, its comparable brand revenue increased 7.4%, while diluted earnings per share jumped 16% to 43 cents, with most of the growth coming from its Pottery Barn and West Elm brands.

As part of its Q2 earnings release Aug. 21, it announced it was opening four Australian stores in early fiscal 2013. They’ll be its first stores outside North America.

All of that’s well and good, but the major reason for my excitement is Williams-Sonoma’s direct-to-customer business, which delivers much higher operating margins and represents 47% of its overall revenue, up from 45% year-over-year. Some experts suggest online revenues could account for as much as 50% of the retail industry’s overall business within 20 years. Williams-Sonoma is positioned better than most to deal with this transition.

Exchange-Traded Funds

Standard & Poor’s lists eight ETFs that use the S&P Mid-Cap 400 as its benchmark, including the S&P 400 MidCap SPDR (NYSE:MDY), which is managed by State Street (NYSE:STT). Competing tooth and nail for mid-cap investors, the iShares S&P MidCap 400 (NYSE:IJH) has $10.4 billion in assets under management, approximately $2.1 billion less than the MDY.

Both of these will get the job done, with the iShares fund slightly less expensive at 0.21%. However, if it were my money, I’d go with the Guggenheim S&P MidCap 400 Equal Weight ETF (NYSE:EWMD), which seeks to replicate the equal-weight version of the same index. The beauty of this fund is that it rebalances quarterly (like most equal-weight funds) to capture profits while reinvesting in the laggards of a given quarter.

As a result you don’t end up with an index that’s top-heavy. It’s more expensive at 0.41%, but worth it in the long run. Since the fund’s inception in August 2010, the equal-weight index has outperformed the market-cap index by 109 basis points annually. It’s the pick of the litter.

Mutual Funds

According to Morningstar, the average three-year return for mid-cap blend funds through Sept. 24 is 12.3%. Therefore, I’m looking for funds that have beat that mark. Although there’s quite a selection, I’m interested only in funds whose expense ratio is less than 1% and whose turnover is less than 20% annually.

My first and only selection is the Fidelity Low-Priced Stock Fund (MUTF:FLPSX), whose expense ratio is 0.83% with 15% turnover. What makes it so attractive is that its lead manager, Joel Tillinghast, has been on board since 1989. While I realize Tillinghast’s eventual departure could set off a sea of redemptions, Fidelity has put in place a team of managers to help with fund management while also learning how Tillinghast does his job so well.

Over the past 15 years, the fund has averaged an annual total return of 11.6%, 213 basis points higher than the mid-cap blend category. It’s not quite Peter Lynch territory, but it’s excellent nonetheless.

As of this writing, Will Ashworth did not own a position in any of the stocks named here. 


Article printed from InvestorPlace Media, http://investorplace.com/2012/09/3-ways-to-play-the-strength-in-mid-caps/.

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