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Middle of the market best performing

Nicki Bourlioufas  |  04 Jul 2017Text size  Decrease  Increase  |  

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Mid-cap shares are an often-neglected segment of the stock market, but in recent times they've outperformed and could continue to do so, even if stock markets correct.

 

Over the year to 29 June, 2017, the S&P Midcap 50 is up around 18 per cent, compared to around 12 per cent for the S&P/ASX 200, while the S&P/ASX Small Ordinaries is up just over 6 per cent. 

While smaller stocks are expected to grow faster than larger stocks, it’s the mid-cap outperformance of small-cap stocks that has attracted attention.

Ross Macmillan, senior analyst, manager research at Morningstar Australasia, says over the past year, the weight of fund managers’ money has moved into mid-cap stocks, away from the large- and small-cap sectors, which helps to explain their outperformance.

“The ASX Top 20 has struggled for growth. The big banks, even before the bank levy was announced, were only forecast to have around 1 per cent earnings growth and Telstra too has struggled.

“As a result, large cap fund managers have been looking in the mid-cap space for growth. They have been moving out of the ASX top 20 stocks which is dominated by banks and miners, to the bottom of the ASX 200, which is more diverse,” says Macmillan.

“Mid-caps are more exposed to the growing US and Asian economies than the domestically-focused banks. There are more technology stocks, agricultural companies, healthcare stocks and other companies which are investing in research and development and capital spending on projects. So, there is more growth in that particular part of the market than in the Top 20,” he says.

A stock is considered a mid-cap if its market capitalisation is between $500 million and $5 billion, though some experts let that valuation go up to $10 million. In Australia, mid-caps are often referred to as the stocks on the S&P/ASX 200, not including the leading 50 companies on the S&P/ASX 50.

During the 2016 calendar year, more than 400 stocks rose 50 per cent or more in value. Just three companies on that list were large caps: Fortescue Metals, Newcrest Mining and BHP spin-off South32. Even those three had a market cap of significantly less than $10 billion at the beginning of the year.

As for the small-cap sector, Macmillan says their underperformance is more closely defined to economic activity, which has been lacklustre.

“Many small-cap fund managers have also been moving into the mid-cap space to capture the growth there. Mid-caps companies are offering better prospects, given their growth capital spending and investment in growth, and there is diversification, so the mid-cap space is giving fund managers lots of opportunity,” he said.

According to Fidelity International, another reason to invest in smaller stocks is that they tend to be takeover targets.

“Not only does a takeover offer propel the target’s share price to unexpected heights ... the tendency for larger companies to swoop on smaller ones often means that mid- and small-caps trade above what they otherwise would.”

Macmillan agrees and says greater merger activity is bringing rewards to shareholders. “At the moment, for example, Tabcorp (ASX: TAH) and Tatts (ASX: TTS) are merging into one company. There is also Fairfax (ASX: FXJ), which has attracted private equity interest.”

Another target has been Spotless (ASX: SPO), whose shares bounced back over $1 after Downer EDI (ASX: DOW) announced a takeover bid in March.

According to Fidelity, “smaller stocks can contain turnaround stories too. Some large stocks flounder for a while and become so unloved they slip out of the top 50. Such a drop can inspire a shakeup that revamps a company. Qantas Airways (ASX: QAN) has staged such a turnaround in recent years,” the fund manager says.

Another important distinction between midcaps is that they often pay dividends. “Mid-caps typically have greater organic earnings growth capacity, cash flow and well-established profits … Mid-caps generally have greater scope for dividends than small-caps, which often use their cash to fund expansion,” says a research note from BT Investment Management.

Given their greater exposure to offshore economic activity and a heavy focus on cost cutting in recent years, Macmillan adds that mid-caps may be “more resilient” during a domestic downturn or housing correction than large caps.

More from Morningstar

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Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.