If there is a sweet spot in the market for growth, mid-cap stocks are it. Many mid-sized companies exhibit the growth characteristics of small companies and the financial stability of large ones, yet they are often overlooked by investors.
Why? Well, the largest companies garner the attention of Wall Street banks because they pay those banks hefty fees for investment banking services — initial public offerings, issuing bonds, advice on mergers and acquisitions, etc. The media focuses its attention on the large “household” name companies because it makes the story relevant to the listeners’ lives.
At the same time, smaller companies with their higher risks and higher potential returns grab the attention of risk takers. It’s the middle ground that gets lost in the sauce.
As a result, investors may be missing a wonderful opportunity, as the long-term returns tell a pretty bullish story.
Mid-Cap Stocks: Just Right
The chart below of the relative performance of Russell indexes over 35 years or so, shows that in the long run, mid-cap stocks have outpaced both their larger and smaller siblings.
The blue line compares the Russell MidCap index (IWR) and the Russell Top 200 index (large-cap stocks, IWL). When the line is rising, mid-cap stocks are outperforming large caps. The red line compares the mid-cap index to the Russell 2000 index (small-cap stocks, IWM), and again rises when mid-caps outperform.
To put some numbers behind the chart, over more than three decades, the Russell MidCap index returned 13.8% a year — about 2% better per year than both the Russell Top 200 and the Russell 2000 indices.
A 2% annual advantage may not seem like much, but it really adds up over time.
One hundred dollars invested in the Russell MidCap Index at the end of 1978 would have grown to $10,367 by the end of 2014. Meanwhile, a similar investment in large-cap stocks (Russell Top 200) would have grown to just $4,974. And small-cap stocks, as measured by the Russell 2000 index, would have turned that $100 into $5,683.
As the chart shows, this return edge is not the result of one outstanding period, as mid-caps held their advantage in different environments and cycles.
An investment rule of thumb is that with higher returns comes higher risk, but mid-cap stocks turn that chestnut upside down. The table below shows the maximum cumulative loss (or drawdown) and the time it took to recover from the losses for the Russell indices during the four big bear markets over the past 35 years or so.
The Russell MidCap index’s steepest decline, a loss of 54.2% reached during the financial crisis of 2007-09, was deeper than that experienced by small- and large-cap stocks, but not by much. And if we look beyond the financial crisis, mid-cap stocks actually experienced lower drawdowns than their siblings. Additionally, mid-cap stocks tended to recover faster from those declines.
So for fairly significant extra return, investors historically haven’t had to take on extra risk.
A sweet spot, indeed.
Editor/Research Director Jeffrey DeMaso helps publish The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Indepedent Guide to the Vanguard Funds.