Golfers refer to the "sweet spot" as the position on the face of the club head that when hit produces the maximum result. A very similar result occurs when investing in mid-cap stocks, those companies with market capitalizations ranging from $2 billion to $10 billion. Most often, they are established businesses sandwiched between slower growth large-cap multinationals and faster growing small-cap businesses. In recent years, mid-cap stocks have outperformed both their large-cap and small-cap peers with very little added risk. It's as if they have hit the sweet spot of performance. In this article, we examine the key attributes of mid-cap stocks including how to analyze them and why you should consider these often-misunderstood stocks for your portfolio. (For related reading, see What Is A Small Cap Stock?)

TUTORIAL: Guide To Stock Picking Strategies

Why Include In Your Portfolio
Having already established that the historical performance of mid-cap stocks is equal to or in many cases better than both large-cap and small-cap stocks, it's important to point out that performance isn't the only reason why you should include mid-caps in your portfolio. Several others make them very tempting indeed. For example, most mid-caps are simply small-caps that have grown bigger. Additional growth makes them the stepping-stones to becoming large-cap businesses. Part of growing is obtaining additional financing to fuel expansion. Mid-caps generally have an easier time of it than small-caps do.

While mid-caps have an advantage over small-caps when it comes to raising funds, their advantage over large-caps amounts to earnings growth. Smaller in size, mid-caps often have yet to reach the mature stage where earnings slow and dividends become a bigger part of a stock's total return. Possibly the most overlooked reason for investing in mid-caps is the fact that they receive less analyst coverage than large-caps. Some of the best performing stocks historically have been unloved companies that suddenly became loved, producing the institutional buyers necessary to move their price higher. Some call this the "money flow." Call it what you will, institutional support is vital to a rising stock price. In the end, investing in mid-caps makes sense because they provide investors with the best of both worlds. Small-cap growth combined with large-cap stability. (These big players can both create and destroy value for shareholders. For more, see The Pros And Cons Of Institutional Ownership.)

Profitability
One of the beautiful things about mid-cap stocks is that you're investing in businesses that are generally profitable, have been for some time and possess seasoned management teams. This doesn't mean they've stopped growing; on the contrary, the average mid-cap's earnings tend to grow at a faster rate than the average small-cap while doing so with less volatility and risk. In addition to earnings growth, it's important to find stocks whose earnings are sustainable for many years to come. That's what turns a mid-cap into a large-cap. Telltale signs indicating whether a company's earnings are heading in the right direction include higher gross and operating margins combined with lower inventories and accounts receivable. If it routinely turns its inventory and receivables faster, this usually leads to higher cash flow and increased profits. All of these attributes help reduce risk. Mid-caps tend to possess these attributes more frequently than other market caps. (For more, see Analyzing Operating Margins.)

Financial Health
Whatever size stock you're interested in, it's important to invest in companies with strong balance sheets. Benjamin Graham used three criteria to assess the financial health of a company:

  • Total debt that is less than tangible book value. Tangible book value is defined as total assets less goodwill, other intangible assets and all liabilities.
  • A current ratio greater than two. Current ratio is defined as current assets divided by current liabilities. It is an indication of a company's ability to meet its short-term obligations.
  • Total debt less than two times net current asset value. Companies meeting this criterion are able to pay off their debts with cash and other current assets making them far more stable.

Given the unpredictability of business, a strong balance sheet can help companies survive the lean years. Because mid-caps tend to have stronger balance sheets than small caps, this reduces risk while providing superior returns to large-caps. When investing in mid-caps, you are in a sense combining the financial strength of a large-cap with the growth potential of a small cap with the end-result often being above-average returns. (For related reading, see Testing Balance Sheet Strength.)

Growth
Revenue and earnings growth are the two most important factors in long-term returns. In recent years, mid-cap stocks have outperformed both large-cap and small-cap stocks because of their superior growth on both the top and bottom lines. Industry experts suggest mid-caps are able to produce better returns because they are quicker to act than large-caps and more financially stable than small-caps, providing a one-two punch in the quest for growth.

Investors interested in mid-cap stocks should consider the quality of revenue growth when investing. If gross and operating margins are increasing at the same time as revenues, it's a sign the company is developing greater economies of scale resulting in higher profits for shareholders. Another sign of healthy revenue growth is lower total debt and higher free cash flow. The list goes on and while many of the criteria investors use to assess stocks of any size definitely apply here, it's vitally important with mid-caps that you see progress on the earnings front because that's what's going to turn it into a large-cap. Revenue growth is important but earnings growth is vital. (For more, see Earnings: Quality Means Everything.)

Reasonable Price
Nobody wants to overpay when shopping, and buying stocks are no different. Warren Buffett believes, "It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Many refer to people interested in growth at a reasonable price as GARP investors. Some of the things GARP investors focus on when evaluating mid-cap stocks include growth measures like sales and earnings growth rates along with value measures like price/earnings and price/cash flow. Whatever measures you choose, the most important criteria should be the quality of the company. As the Oracle of Omaha says, it doesn't make sense to get a great deal on a dud company. Deep-value investors might disagree but true GARP followers are simply looking to avoid overpaying, not obtaining the deal of the century. (They don't call him "The Oracle" for nothing. For more, see Think Like Warren Buffett.)

Stocks Or Funds
Investing in mid-caps is an excellent way to simultaneously diversify and enhance the performance of your investment portfolio. Some investors will find there's too much work involved in evaluating individual stocks and if that's you, an excellent alternative is to invest in exchange-traded funds or mutual funds, letting the professionals handle the evaluation process. Whatever your preference is, mid-caps are definitely worth considering. (For more, see Mutual Fund Or ETF: Which Is Right For You?)

Related Articles
  1. Mutual Funds & ETFs

    The Top 5 Mid-Cap Growth Mutual Funds for 2016

    Understand how mid-cap growth equities play a part in asset allocation, and discover the best mid-cap growth funds to consider for 2016.
  2. Mutual Funds & ETFs

    MYY: ProShares Short MidCap400 ETF

    Discover the benefits and drawbacks of the ProShares Short MidCap400 ETF, and learn which investors are best suited for the fund's investment strategy.
  3. Mutual Funds & ETFs

    Top 3 Allianz Funds for Retirement Diversification in 2016

    Discover the top three Allianz funds for retirement diversification in 2016, with a summary of the portfolio's managers, performance and risk measures.
  4. Mutual Funds & ETFs

    The Top 5 Large Cap Core ETFs for 2016 (VUG, SPLV)

    Look out for these five ETFs in 2016, and learn why investors should closely watch how the Federal Reserve moves heading into the new year.
  5. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  6. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  7. Stock Analysis

    Analyzing Baidu's Return on Equity (ROE) (BIDU)

    Find out how Baidu's return on equity (ROE) compares to industry peers and historical results. See how DuPont analysis treats net margin, asset turnover and leverage.
  8. Mutual Funds & ETFs

    The 4 Best American Funds for Growth Investors in 2016

    Discover four excellent growth funds from American Funds, one of the country's premier mutual fund families with a history of consistent returns.
  9. Mutual Funds & ETFs

    The 4 Best Vanguard Funds for Growth Investors in 2016

    Discover four mutual funds managed by the Vanguard Group that would be attractive for investors interested in investing in growth stocks in 2016.
  10. Stock Analysis

    3 Reasons to Invest in Frontier Markets in 2016

    Learn why investing in frontier markets will be a great long-term investment as these markets grow in ways that will propel them to success in the future.
RELATED FAQS
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  3. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  4. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  5. What is the formula for calculating the debt-to-equity ratio?

    Expressed as a percentage, the debt-to-equity ratio shows the proportion of equity and debt a firm is using to finance its ... Read Full Answer >>
  6. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
Hot Definitions
  1. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  2. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  3. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  4. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  5. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
Trading Center