Often overlooked, mid cap companies tend to be more stable and established than small caps but are also growing faster than large, more mature companies. Mid caps typically capture the stage in an enterprise life cycle characterized by both a proven business model and a significant runway for potential growth. These companies are defined by a market capitalization between $1 billion and $50 billion.
Relative to large caps, mid caps tend to be under-followed by Wall Street analysts, leaving greater variance in valuation estimates and room for active investment managers to find strong businesses at attractive prices.(1) Relative to small caps, mid caps tend to be more diversified businesses, with pricing power at both the input (raw materials, labor, etc) and product output levels, greater access to capital markets, and an ability to adapt to changing environments.
Becoming more reliable and stable as they grow out of the young and rapid-growth small cap stage, mid caps are not as limited in their future growth prospects as large caps. Active managers can exploit market inefficiencies (price variations) in the fertile mid cap space to find the next large cap company at an attractive price.
What is considered “mid cap”?
Within the equity market universe, mid caps typically reside between the largest 200 companies and those with market caps below $1 billion. Because of the makeup of broad market, cap-weighted indices, there tends to be some overlap between large and mid, and mid and small. For instance, the Russell 1000® Index is designed to measure the top 1000 U.S. stocks; the bottom 800 stocks within this index make up the Russell Midcap Index. This does not mean the Russell Midcap Index has an 80% overlap with the Russell 1000®. Due to weighting by market capitalization, the largest 20% of stocks make up about 77% of the Russell 1000® Index.
Mid cap risk and return
When examining historical performance, the case for mid caps becomes even more compelling. Relative to other asset classes, mid caps have produced a higher average annual return and lower volatility. Over the last 25 years, the Russell Midcap Index returned 9.3% annually, compared to 7.6% for the S&P 500 (large cap), 7.7% for the Russell 1000 (large cap), and 7.9% for the Russell 2000 Index (small cap).
Over the same time period, the Sharpe Ratio for mid caps was 0.49%, compared to 0.43%, 0.43%, and 0.38% for the S&P 500, Russell 1000, and Russell 2000, respectively. Sharpe ratio measures risk-adjusted performance, calculated by comparing an investment’s return to that of a risk-free asset, such as a treasury bill or bond.
Mid cap performance following a recession or major market drawdown
Mid caps have shown an ability to emerge from significant downturns stronger than their large and small cap counterparts. Looking at the three years following the most recent market drawdowns4, mid caps have outperformed large caps in each instance by an average of 32.85 percentage points and small caps in two of the past three periods by an average of 13.22 percentage points. (2)
Mid caps in an asset allocation portfolio
This performance does not happen by chance. As demonstrated by the long-term risk-adjusted returns in relation to both large caps and small caps, as well as how mid caps have historically fared following significant market downturns, we believe mid caps have earned the right to be viewed as a stand-alone component in an investment portfolio. While every market cycle presents new and unique risks, investors should consider how mid caps fit into the economy, markets, and investment portfolios.
Qualities of mid cap stocks
Nimbleness: While their business model tends to be more established and mature than smaller companies, it is less complex than large caps, giving them a greater ability to adapt to changing economic conditions.
Revenue: While large caps tend to have operations around the globe, mid caps typically derive most of their revenue from within the U.S. This helps these companies reduce the impact of international risk dynamics and currency fluctuations.
Valuation: Relative to large-caps, mid caps tend to be under-followed by Wall Street analysts, leaving greater variance in valuation estimates and room for active investment managers to find strong businesses at attractive prices.
Flexibility: The breadth of the mid cap universe provides opportunities for managers to reach into the large or small cap space without compromising the portfolio’s mid cap character.
About Madison Mid Cap
Madison’s Mid Cap Equity strategy is a concentrated portfolio of 25-40 mid cap stocks. To pursue the goal of superior risk-adjusted returns, the team conducts extensive research to identify high quality companies with sustainable competitive advantages, high returns on capital, durable growth, shareholder-oriented management, and strong balance sheets.