When it comes to investing, there are countless strategies and styles aimed at trying to maximize profit amid an acceptable level of risk. Given the diversity of the markets, it is as common to find an investor who is looking to buy shares of individual companies that meet specific metrics as it is to find another who wants to reduce company-specific risk and buy into funds that track broad sectors or markets.
One segment of the market that is well poised to capture the attention of all types of investors is known as the mid-caps, which are those companies in the market that have a market capitalization between $2 billion and $10 billion. In this article, we'll look at several common investing strategies that are utilized by investors seeking to gain exposure to mid-cap companies.
- Passive buy-and-hold strategies are employed by investors interested in mid-cap companies mainly through the use of exchange-traded funds (ETFs).
- Identifying growth and value stocks within the mid-cap segment is among the popular investment strategies, and these stocks are the focus of many mid-cap ETFs.
- Investors can create custom investment strategies by combining any qualitative or quantitative factor that is of particular interest.
Mid-Cap Market Segment
The mid-cap segment is considered by many investors to be the "sweet spot" of the market. Mid-cap companies are medium-sized businesses and are found in the middle of the business cycle, which means they no longer carry the same amount of survival risk they did when they were smaller. Though mid-cap companies aren't as well established as the household names that comprise the large-cap segment, most companies that trade within this group are well-positioned for the future.
The mid-cap segment tends to be relatively underfollowed by both retail and institutional investors despite strong levels of relative performance. According to S&P Dow Jones Indices, the S&P MidCap 400 has beaten the S&P 500 and the S&P SmallCap 600 by an annualized rate of 2.03% and 0.92%, respectively, between December 1994 and May 2019. This type of strong relative performance could suggest that passive investors may be interested in gaining broad exposure to the entire mid-cap segment.
Many investors use a passive buy-and-hold strategy to gain broad exposure to the mid-cap segment. This type of strategy is best carried out using exchange-traded funds (ETFs) such as a blended mid-cap ETF that carries low fees and is designed to track a well-known mid-cap benchmark such as the S&P 400, CRSP U.S. Mid Cap Index, or Russell MidCap Index.
With most ETFs that target a certain market segment, there are slight differences between the funds based on the composition of the underlying constituents, which is something worth considering before you invest. Some common mid-cap focused ETFs based on total net assets are the iShares Core S&P Mid-Cap ETF (IJH), Vanguard Mid-Cap ETF (VO), iShares Russell Mid-Cap ETF (IWR), and SPDR S&P MIDCAP 400 ETF Trust (MDY).
Buy-and-hold investors tend to outperform active management, on average, over longer time horizons and after fees, and they can typically defer capital gains taxes.
Mid-Cap Value Stocks and ETFs
Value investors are on the lookout for companies that have share prices that are trading for less than their intrinsic value. Put more simply, this means that value investors try to identify companies that have share prices that are cheap or on sale relative to what the investor believes the true value ought to be. To determine when a stock is on sale, value investors often turn to financial metrics such as price-to-book, price-to-earnings, free cash flow, and a variety of others. In essence, value investors utilize all public information and any research-driven insight to determine what they view as a fair price. If the market price is less than the investor's researched price, then the stock becomes a candidate for investment.
Of course, investors can build a portfolio of value stocks based on their research, but many retail investors lack the time, skill, or interest required to conduct the necessary research that is essential to long-term success. Investors who want to apply a value-investing approach to the mid-cap segment will be interested to know that there is a wide variety of ETFs to choose from. Some examples include the Vanguard Mid-Cap Value ETF (VOE), iShares Russell Mid-Cap Value ETF (IWS), iShares S&P Mid-Cap 400 Value ETF (IJJ), and SPDR S&P 400 Mid-Cap Value ETF (MDYV).
Mid-Cap Growth Stocks and ETFs
Another type of investment strategy that is commonly applied to the mid-cap segment is focused on investing in companies that are expected to increase their earnings at an above-average rate compared to the rest of the sector or market. Strong and consistent earnings growth suggests that a mid-cap company could be on its way to becoming a large-cap and that the investor could be into their position early enough to make a substantial profit. Growth investors anticipate that share prices of the companies they've identified could soon demand a higher premium based on increasing earnings when recognized by the broader market.
Investors who are interested in exposure to mid-cap growth companies may want to consider one of the growth-oriented mid-cap ETFs. Some examples to consider include the Vanguard Mid-Cap Growth ETF (VOT), SPDR S&P 400 Growth ETF (MDYG), and iShares Morningstar Mid-Cap Growth ETF (IMCG).
Targeted or Custom Investing Strategies
As mentioned earlier, there are countless strategies when it comes to investing in mid-caps. The root of why there can be so many different strategies comes from the fact that potential investment candidates can be identified by filtering based on myriad qualitative or quantitative factors.
Qualitative factors are those that are difficult to identify numerically or by using traditional screening techniques because the factors of interest are intangible by nature. Some examples of qualitative factors include the type of corporate culture, management experience, and product quality.
Quantitative factors are those that have associated data points, which can then be compared about the same data points from other companies within the sector or the broader market. Quantitative factors include the data points and derived ratios or indicators that come from sources such as corporate financial statements, historical stock prices, or industry reports. Some examples of quantitative factors include earnings per share (EPS), spending on research and development (R&D), debt-to-equity (D/E) ratio, and net profit margin.
Investors can mix any number of qualitative and quantitative factors when it comes to building out their custom strategies.
What Metrics Can Help Identify Value Stocks?
Value investing is a strategy for identifying undervalued stocks based on fundamental analysis. Some common metrics value investors use include a price-to-earnings ratio (P/E), price-to-book ratio (P/B), debt-to-equity ratio (D/E), free cash flow (FCF), and price/earnings-to-growth ratio (PEG).
Are ETFs Risky to Use As Part of an Investment Strategy?
All investment strategies carry a certain element of risk. ETFs, like mutual funds, are often lauded for the diversification they offer investors. However, it is important to note that just because an ETF contains more than one underlying position doesn't mean that it is immune to risk and volatility. The potential for large swings will mainly depend on the scope of the fund. As investors, it is important to know what benchmark an ETF is designed to track, what types of companies are held within the fund, and whether the ETF lacks liquidity or utilizes leverage.
What Is an Example of a Growth Stock?
As a hypothetical example, a growth stock could be a mid-cap tech company that has recently started a new division to focus on the development of a new virtual reality app. Let's assume that the company has aspirations of expanding into international markets. Currently, the product is only available in the United States and has been adding new users at blinding speed. Earnings and revenue have been growing at a high rate over the past couple of years. If the app is well received in the new markets, it could mean huge profits and capital gains for investors.
The Bottom Line
Investors who are interested in gaining exposure to mid-cap companies can utilize a host of different types of strategies. Investors who want to take a passive approach and capture returns that closely match an underlying benchmark such as the S&P 400 may be interested in adding a position in a blended mid-cap ETF.
Other investors may be interested in identifying candidates that exhibit certain value or growth characteristics. More specifically, those that are drawn to more common value and growth strategies may be interested in one of the many available strategy-specific funds that target the mid-cap segment.
Lastly, more adventurous investors may want to consider building out their strategies by identifying qualitative or quantitative factors that resonate and then combining them in a way that meets their investment goals.
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