Investing in Mid-Cap Companies: Advantages and Disadvantages

For many people, the size of a corporation is often measured by metrics such as the number of employees, overall sales, or popularity of its products. However, for investors, the relative size of a company is measured by its market capitalization, also known as market cap, which is equal to the total number of shares outstanding multiplied by its market price.

In simpler terms, market capitalization is the amount of money it would take to buy all the shares of a company at the current market price. The reality of buying all the shares of a company is much more complicated and includes considerations around regulatory requirements and various types of closing costs. However, market cap is a useful gauge of where the company fits in size-wise relative to its peers, or other public companies in general. Public companies come in all sizes. As of early April 2022, the market capitalization of companies trading on the Nasdaq was ranging anywhere from $2 million to more than $2 trillion.

If a person were to sort all publicly traded companies across all markets by market capitalization, it would be an extensive list. To make research tasks more manageable, commonly used groupings based on market cap have been created to help narrow the list. Common groupings are nano-cap (market caps less than $50 million), micro-cap ($50 million to $300 million), small-cap ($300 million to $2 billion), mid-cap ($2 billion to $10 billion), large-cap ($10 billion to $200 billion), and mega-cap (more than $200 billion). Notice how each grouping has an upper and lower boundary that helps define its range. Those mentioned are the most common but can vary depending on the screener or investor interest.

The swath of companies in the middle of the list—or those with market capitalizations that generally fall between $2 billion and $10 billion—are of particular interest to many investors and will be the focus of this article. In the paragraphs below, we'll look at the pros and cons of this group and why it is a market segment that is worthy of your time and research.

The Advantages of Investing in Mid-Cap Companies

It is widely known that the survival rate for new businesses is extremely low. Data from the U.S. Bureau of Labor Statistics (BLS) shows that approximately 30% of new businesses fail within two years of opening. Worse yet, 45% fail during the first five years and 65% fail during the first 10 years.

Within a normal business lifecycle, it is safe for investors to assume that medium-sized companies have successfully navigated the high-risk phases associated with startups and early market development. For investors, it can mean that there is a lower level of investment risk associated with medium-sized companies because they have a proven level of staying power. Though not true in all cases, the larger size can also help improve the survival rate because it often means that management has access to more resources and business opportunities than they did in the early days of the business.

Historically, mid-cap companies have posted strong performance relative to their more popular large-cap counterparts. According to research conducted by S&P Dow Jones Indices, mid-cap companies, as measured by the S&P MidCap 400 Index, outperformed the S&P 500 and S&P 600 between Dec. 30, 1994, and May 31, 2019, at an annualized rate of 2.03%, and 0.92%, respectively.

Despite the strong performance, the mid-cap segment is relatively underfollowed by retail and institutional investors across the different size segments. According to the report, the mid-caps are also underrepresented within the mutual fund universe. Between 2003 and 2018, the mid-cap segment was the only one that noticed a decline in the number of active funds. The apathy shown by the majority of investors toward mid-caps suggests that there is ample room for opportunity for those willing to do the research.

Prospects for Growth

Though companies ranging in size from $2 billion to $10 billion seem large to small business owners or new investors, in the realm of the public markets, these companies offer plenty of upside potential. Midsized companies can often access cheaper forms of financing than they were able to when they were smaller. Increased levels of capital, whether from financing or existing business, can in turn fund future growth through new lines of business, hiring more employees, opening new offices, utilizing new equipment, or even participating in corporate actions such as mergers or acquisitions.

Retail and institutional investors are not the only entities interested in the investment prospects of midsized companies. More specifically, larger corporations often target midsized companies as a mechanism for growth. They buy small and medium-sized companies because they seek to gain a comparative advantage but at a lower cost than what it would take to implement the changes otherwise. This type of acquisition is known as a tuck-in acquisition, or bolt-on acquisition. A buyout is an event that often comes at a significant premium to the market price and can be a catalyst for considerable return on investment.

The Disadvantages of Investing in Mid-Cap Companies

The road to becoming a mid-cap company is often long and challenging. Typically, decades of effort have been spent growing and nurturing the company. Like many things in life, certain traits or characteristics that were advantageous in one situation can also be disadvantages in another. For example, in the case of a medium-sized business, management styles that serve a company well when it is smaller don't necessarily work as well after it has grown. Demands from suppliers, investors, and employees, along with new forms of competitive market forces, change as the company grows. Though these evolutionary pressures aren't inherently a disadvantage, management response to them can be. It's the investor's task to discern whether changes to the risk profile are acceptable.

Another disadvantage to investing in mid-cap companies is that they aren't as well known as their larger-cap counterparts. In many cases, products of mid-cap companies are just starting to gain household recognition. What this means for investors is extra time spent on research and analysis. Some types of investors only look to buy into companies that are considered best of breed, which in many cases are large- or mega-caps.

However, should an investor be able to identify a best-of-breed type investment with a market cap within the mid-cap range, then they may end up frustrated to see the company acquired in a bolt-on type of acquisition. Depending on the details of the transaction relative to entry costs, it can often seem that the long-term potential of the investment is transferred to the acquirer rather than the investor.

Special Considerations

In finance, liquidity represents the ease with which invested assets can be converted to cash. For most investors, the liquidity of mid-cap companies is not really a concern, but it is something to consider on a case-by-case basis. Depending on investing style and level of sophistication, it is also worth noting that the options market for mid-cap companies is also not as active, and options contracts can have significant spreads between bid and ask prices.

Mid-Cap ETFs

Investors who are not interested in researching and analyzing the broad mid-cap segment may want to consider investing in one or more of the targeted exchange-traded funds (ETFs) that are now available in the market. There are many ETFs with a focus on the mid-caps. Fund options can be narrowed further for those who want to focus on factors such as growth, value, dividends, or momentum. Some examples include:

• SPDR S&P MidCap 400 ETF Trust (MDY)
• Vanguard Mid-Cap ETF (VO)
• iShares Russell Mid-Cap ETF (IWR)
• Vanguard Mid-Cap Value (VOE)
• Vanguard Mid-Cap Growth (VOT)
• iShares Core S&P Mid-Cap ETF (IJH)
• Invesco S&P MidCap Value with Momentum ETF (XMVM)

The Bottom Line

The mid-cap segment of the market is relatively underfollowed by the investing public. In many cases, investors are more interested in well-known large caps or the lucrativeness of the up-and-coming small caps. Because the mid-cap segment has moved beyond the risks associated with early business development, the group is sometimes viewed as less exciting. However, factors such as strong performance, established market position, and opportunity for growth, all with a reasonable level of risk, suggest that the mid-cap group is a worthy candidate for nearly any portfolio.