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.)

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.)

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

    ETF Analysis: ProShares Short MidCap400

    Discover the benefits and drawbacks of the ProShares Short MidCap400 ETF, and learn which investors are best suited for the fund's investment strategy.
  2. Economics

    Calculating Days Working Capital

    A company’s days working capital ratio shows how many days it takes to convert working capital into revenue.
  3. Chart Advisor

    ChartAdvisor for October 2 2015

    Weekly technical summary of the major U.S. indexes.
  4. Chart Advisor

    Weakness In Biotech Will Likely Continue

    You can breathe easy with your biotech holdings--assuming you aren't counting on them to make you rich.
  5. Investing

    What is EBITA?

    EBITA measures a company’s full profitability before reducing it by interest, taxes and amortization considerations, and so is useful for calculating a company’s internal efficiency or profitability ...
  6. Term

    What Is Financial Performance?

    Financial performance measures a firm’s ability to generate profits through the use of its assets.
  7. Investing

    Middle Market Investment Banks

    We take a close look at investment banks working with middle market companies.
  8. Investing

    How to Effectively Monitor Your Stock Holdings

    Investors should concentrate on the business, not the stock price.
  9. Stock Analysis

    AT&T Stock: A Dividend Analysis

    Discover analysis of AT&T dividend policies, and explore the dividend policies of its main competitors, China Mobile Limited and Verizon Communications.
  10. Economics

    Understanding Explicit Costs

    Common examples of explicit costs include wages, utilities, rent, raw materials, and other direct expenses companies pay to conduct business.
  1. Does working capital include inventory?

    A company's working capital includes inventory, and increases in inventory make working capital increase. Working capital ... Read Full Answer >>
  2. Does working capital include salaries?

    A company accrues unpaid salaries on its balance sheet as part of accounts payable, which is a current liability account, ... Read Full Answer >>
  3. Are dividends considered an asset?

    Whether dividends paid on stock are considered an asset depends on which role you play in the investment: the issuing company ... Read Full Answer >>
  4. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  5. What is a profit and loss (P&L) statement and why do companies publish them?

    A profit and loss (P&L) statement, or balance sheet, is essentially a snapshot of a company's financial activity for ... Read Full Answer >>
  6. How do dividends affect the balance sheet?

    Dividends paid in cash affect a company's balance sheet by decreasing the company's cash account on the asset side and decreasing ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!