Many cautious investors lean toward the stocks of large companies because the stocks tend to be not too volatile…while many aggressive investors focus on riskier stocks of small companies.
But there are many benefits to taking the middle road. Stocks of middle-sized companies—so-called mid-cap stocks-have outperformed both large- and small-cap stocks over the past 20 years by an average of about two percentage points a year. Moreover, mid-cap stocks have accomplished this with much less volatility than small-caps. Reason: Medium-sized companies, which typically have stocks with market values (or capitalizations) between $2 billion and $10 billion, offer an attractive blend of strong growth potential and moderate risk. These companies tend to have steadier balance sheets and more seasoned management than the small fry.
Bottom Line/Personal asked top mutual fund analyst Todd Rosenbluth why he thinks most investors should have a heavy dose of mid-cap stock mutual funds in their portfolios and which of those funds are most attractive now…
WHY MID-CAPS IN 2014
Unlike last year, 2014 is shaping up as a tricky, up-and-down year for investors. Staking out the middle ground is likely to pay off.
The US economy is expected to pick up speed, with annual growth in gross domestic product (GDP) reaching 3% as business and consumer confidence strengthens and Europe moves out of recession. But lots still can go wrong. The bull market is entering its sixth year. Stock valuations are no longer low. And the Federal Reserve is scaling back the massive bond-buying program that has helped support higher stock prices.
If the US economy does heat up, I expect the Standard & Poor’s 500 stock index, which is full of large-cap stocks, to have high single-digit returns. Mid-cap stocks could do even better than that, as they did last year.
Although I don’t rule out funds that lean toward beaten-down stocks, especially if you have limited stomach for risk, this year I like funds that are focused on rapidly growing companies. The improving economy is likely to favor faster growers.
Six of the best mid-cap no-load mutual funds, all rated five stars by my firm, S&P Capital IQ…
FOR AGGRESSIVE INVESTORS
These funds invest in companies that have very high growth potential…
Hodges Fund (HDPMX). Don Hodges, who has managed the Hodges Fund for 21 years, shapes a portfolio that mixes investments in high-flying tech and biotech stocks with investments in out-of-favor companies with strong balance sheets. The fund gained 57% in 2013, putting it in the top 1% of its category, and gained an annualized 9.5% over the past 10 years, compared with 7.2% for the S&P 500. However, it can be volatile-it lost 49.5% in 2008, compared with a loss of 37% for the S&P 500. Top holdings: Micron Technology…United States Steel Corporation. Performance: 29.7%.*
Akre Focus Fund (AKREX). Although this fund is relatively new, manager Charles Akre racked up superb returns over a dozen years using a similar style at the FBR Focus Fund. The fund invests in a small number of stocks, recently 28, but avoids high-risk technology stocks that often appear in mid-cap growth funds. Instead, Akre looks for companies he calls “compounding machines” that generate enormous cash flow and can grow steadily year after year, a major reason Akre’s performance has been relatively good in all types of market environments. The fund’s average market capitalization hovers between mid- and large-cap territory because Akre is willing to hold on to medium-sized businesses as they get bigger if he sees continued opportunities. Top holdings: Specialty insurer Markel…off-price retailer Ross Stores. Three-year performance: 21.4%.
Wells Fargo Advantage Discovery Fund (STDIX). The fund uses an aggressive approach, replacing about 86% of its holdings over the past year. It buys stocks even if the share prices are high, as long as the managers believe that the companies can increase revenue and earnings faster than Wall Street analysts generally forecast over the next 12 months. Industrial companies made up about one-third of the 87-stock portfolio recently as the managers believe that those companies will be helped by the improving economy. The fund gained 42% last year and ranks in the top 9% of its category over the past decade. Top holdings: Railroad operator Kansas City Southern…Westinghouse Air Brake Technologies. Performance: 29%.
FOR MODERATELY AGGRESSIVE INVESTORS
These funds invest in companies that have the potential for more modest but steadier growth. Their stocks often sell at relatively low prices in relation to their earnings and other valuation measurements. They tend to hold up relatively well when the market is sliding.
Diamond Hill Small-Mid Cap Fund (DHMIX). The fund buys and holds beaten-down mid- and small-cap stocks that manager Chris Welch believes are trading at a discount to what they are really worth. Welch is finding the most value now in the financial-services and industrial sectors. During the 2008 financial crisis, the fund’s performance beat more than 90% of its peers, and it should do relatively well if 2014 turns out to be rockier than expected. Top holdings: Hub Group, a shipping and transportation management company…insurance broker Willis Group Holdings PLC. Performance: 29.2%.
Fidelity Low-Priced Stock Fund (FLPSX). This mid-cap fund, which invests in both growth and value stocks, has more than $46 billion in assets spread across about 870 stocks. The fund’s mandate of requiring a purchase price under $35 a share limits the number of large-caps it can invest in. For more than two decades, manager Joel Tillinghast’s performance has surpassed most smaller funds, and in the past 10 years, the fund’s returns ranked in the top 10% of its category. Tillinghast looks for reasonably priced stocks of companies with some kind of compelling competitive advantage that will allow them to grow reliably in up and down markets. The fund has been investing heavily in midsized foreign companies, especially in Europe. This held the fund back in the strong US rally last year but could give it a boost this year because the European markets are likely to do especially well. The fund charges one of the lowest annual expense ratios among actively managed funds in its category, just 0.79%. Top holdings: US and UK insurance company Unum…supermarket chain Safeway. Performance: 26%.
Fidelity Midcap Fund (FMCSX). In recent years, fund manager John Roth, who took over in 2011, has reduced the fund’s volatility by increasing diversification, spreading investments over nearly 200 stocks. That didn’t prevent the fund from gaining an impressive 39% last year, compared with 32.4% for the S&P 500. Roth invests in stocks that he expects to experience long periods of growth because of exciting new products or services or because they had strong growth in the past but faced a temporary setback. Top holdings: Information technology research firm Gartner…electric-car maker Tesla Motors. Performance: 28.3%.
*Performance figures are annualized returns for the five years through February 28, 2014, unless otherwise specified.