Mid caps: a time to shine

In recent weeks, concerns around the breadth and sustainability of the mega-cap narrative have grown. The Magnificent Seven have taken a tumble and in their place hitherto unloved small-caps stocks have been on a tear.

But perhaps mid-cap stocks will receive their time in the sun. We believe mid-cap companies can combine the beneficial features of larger companies-financial stability, sustainable business models, and adaptability-with those of smaller companies-growth potential, niche markets and nimble management. Based on recent valuations, historical relative returns and index composition, our view is that the time may now be right to consider an allocation to mid-cap growth stocks.

A favorable entry point?

In 2023 the valuation gap, the ratio of the forward price/earnings ratios between the Russell Midcap Growth Index and the Russell Top 200 Growth Index, reached a level last observed in late 2001. While that gap has narrowed, valuations still present a favorable potential entry point. As of 6/30/24, that ratio stood at 0.85 compared to the long-term average level of 1.03.

After the dot-com boom, when valuations were last at that level, the Russell Midcap Growth Index outperformed the Russell Top 200 Growth Index by over 9% annualized from October 1, 2001 to September 30, 2006.

Given current valuations, investors tracking a large-cap growth style concerned about valuation or simply a reversion to mean but still favoring a growth style may want to consider a tilt toward mid-cap growth stocks.

It's not all about tech

There's no question that tech has been a dominant theme in 2024 but what happens if that narrative continues to unravel? Is there scope for investors to access growth but without high levels of volatility?

A notable distinction between the Russell Midcap Growth Index and the Russell Top 200 Growth and Russell 1000 Growth indexes is their differing levels of exposure to technology stocks. Not all investors are aware of the exceptionally high technology sector concentration in the large-cap growth market segments or appreciate the distortion this creates. Technology exposure in the Russell Midcap Growth Index was 24.2% as of June 30, 2024, compared to 60.9% in the Russell Top 200 Growth Index and 56.7% in the Russell 1000 Growth Index. This high technology weighting may create performance volatility if market leadership continues to rotate away from tech stocks. We believe the more balanced sector exposure in mid-cap growth stocks may allow participation in an expanding economy without the higher potential volatility associated with a high concentration in the technology sector.

Avoiding style drift

Index providers have clear rules for classifying stocks within a particular index, but active fund managers are not obliged to follow those rules. Managers seeking to outperform their benchmark may look outside the benchmark universe for ideas, leading to size or style drift in the portfolio relative to a benchmark.

A Morningstar analysis of all mid-cap funds indicates that many are not pure mid-cap funds, instead investing meaningful portions in large- and small-cap companies. Choosing a pure mid-cap manager that won't overlap with other strategies may be challenging. This is where a mid-cap strategy adhering to style parameters might help: potentially diversifying an overall equity portfolio and identifying overlooked opportunities.

Choose a path; don't let it be chosen for you

Given the uncertainty around mega caps right now and the scope for rising volatility on the back of rising dispersion we believe an allocation to mid caps makes sense-particularly for those with an eye on growth. Investors can choose to invest with a large or small-cap manager who buys or owns mid-cap stocks. Choosing a focused mid-cap strategy may help complement existing strategies.

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