Mid-caps winning war against COVID-19

The mid-cap sector of the share market has easily outperformed large-caps and small-caps through the coronavirus pandemic, a trend which is tipped to continue over the longer term.

Over the year to date to 6 August, the S&P Midcap 50 has fallen just 2.2 per cent, compared to the benchmark stock market index, the S&P/ASX 200, which has dropped 9.6 per cent, while the S&P/ASX Small Ordinaries is lower 7.0 per cent.

That pattern of stronger performance than large- and small-caps is repeated over the past year and over five and 10-year periods.   

While smaller stocks are expected to grow faster than larger stocks, it is the mid-cap outperformance over small-cap stocks that has drawn attention.

“It is very much a global thing, that mid-caps generally outperform large- and small-caps,” says Ross MacMillan, senior analyst, manager research at Morningstar Australasia. The revenue and earnings of mid-caps are expanding at a faster rate than large caps and their share prices often take bigger leaps.

“A lot of these companies are still in their growth phase. They are no longer a small-cap company, they are more established; their brands are more established, and they have built up competitive advantages. But they still have more growth in them than large-caps,” says MacMillan.

“Some of the top 50 companies such as the banks have been around for 50 years or more and they are very well-established businesses and they don't have that growth profile that mid-caps have.”

The mid-cap sector generally refers to Australia’s 51 to 100 largest companies, which are represented in the S&P/ASX MidCap 50 Index.

Defining the mid-cap sector

The sector is characterised by successful companies which are still maturing and able to achieve greater earnings growth than large-cap companies. The sector also offers more diversification benefits than large caps.

“The mid-cap market has a greater offering of relatively new businesses with strong growth prospects,” says Tribeca Investment Partners’ portfolio manager, Jun Bei Liu.

“In addition, there is a handful of exciting tech businesses in the mid-cap index that we believe have long runways of growth.”

“The tech and gold heavy nature of the index will mean the structural growth tilt of the mid-cap index should perform well over the long term,” says Liu.

She names technology companies Afterpay (ASX: APT), Xero (ASX: XRO) and NextDC (ASX: NXT) as some of the most exciting growth companies in the sector.

“Despite economic challenges with covid-19 impacting most of the companies, Afterpay has actually been the beneficiary of the sharp shift to online purchases and grew its revenue substantially.

“Its share price has rapidly risen from a low of $8 reached in March to $70 and is well on track to be one of the top 20 largest companies in Australia by market cap.”

The mid-cap space also has large exposure to the strong performance by gold miners Northern Star Resources (ASX: NST), Evolution Mining (ASX: EVN) and Saracen Minerals (ASX: SAR).

“Given the substantial outperformance of gold prices, these three have had stellar performances,” says Liu.

Afterpay, Xero and NextDC have been some of the most exciting growth companies in the mid-cap sector

Morningstar’s MacMillan says the earnings profiles of midcap companies have generally been more resilient during the coronavirus pandemic than those of large caps, and a generally less vulnerable to economic shocks.

“Their growth profiles are overall less susceptible to macroeconomic shocks than the earnings of large-cap companies and probably more less susceptible to geopolitical risks and the impacts of the coronavirus pandemic,” says MacMillan.

“They have more exposure to technology, healthcare, utilities, consumer discretionary stocks, so the growth profile of these companies is more resilient.”

Ways to get exposure

For investors keen to invest in mid-caps, MacMillan points to the Morningstar Gold-rated Fidelity Future Leaders Fund. The fund invests in a diversified portfolio of 40 to 70 small-to mid-cap Australian companies.  

In terms of mid-caps expected to outperform, the fund is overweight Ansell (ASX: ANN), REA Group (ASX: REA), Magellan Financial Group (ASX: MFG) and Fisher & Paykel Healthcare (ASX: FPH) and Charter Hall Group (ASX: CHC). But it is underweight Afterpay after its price has rallied hard.

The fund has delivered an annual return of 13.2 per cent  since its inception in 2013, beating its benchmark by the S&P/ ASX Mid Small Index.by 4.1 per cent per annum.

“Paying consistent attention to the viability, sustainability and credibility of positions held in a portfolio has held us in good stead in these troubled times,” says the fund’s portfolio manager, James Abela.

“Risk-pricing is an important consideration, and I do not overlook premium valuations, even for high-quality business models.

“I consistently steer clear of crowded trades where the risk of being ‘too certain’ is often overlooked,” Abela said in a recent market commentary. Going forward, Abela expects to see valuation opportunities arise in global health care, global technology and global consumer brands.”

 Morningstar's Global Best Ideas list is out now. Morningstar Premium subscribers can view the list here.