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This celebrated soft landing is showering some hard profits on investors in midsize companies.
The S&P 400 Midcap Index ($IDX) is up 7.5% this year, as of Feb. 20, more than twice the 2.9% advance of the S&P 500 Index ($INX). That's a reversal from last year, when large companies advanced 13.6% while midcapitalization companies trailed at 9%.
S&P equity strategist Alec Young calls companies with market capitalizations between $1 billion and $7 billion the market's sweet spot, and he believes it will get even sweeter. "When you compare estimated earnings growth for 2007, midcaps really leap off the page," he says. S&P forecasts earnings at midsize companies will zoom ahead 15% this year, compared with projected gains of 8% for large stocks and 10% for small ones.
A moderate economy is ideal for midsize companies that have survived the volatile small-cap world to become household names, including clothier Polo Ralph Lauren (RL, news, msgs) and broadcaster Westwood One (WON, news, msgs). They are more nimble than giant companies and able to compound earnings at a higher rate.
They are also, however, the most neglected segment of the market, often ignored by academics, Wall Street analysts and institutional investors. "Midcaps remain largely undiscovered," Young says, with investors willing to seek them out only when other segments falter.
Mutual fund investors have abundant choices among portfolios that concentrate on this corner of the market. I've identified five, including one exchange-traded fund (ETF) and one overseas fund, that should do particularly well this year.
Room to grow
I'll throw in one caveat: The three domestic midcap mutual funds I like the best do not represent style purity. Each owns small stocks, and some own larger ones. But midcaps dominate their portfolios.(Full disclosure: I own two other midcap funds, T. Rowe Price Mid-Cap Growth (RPMGX) and T. Rowe Price Mid-Cap Value (TRMCX), but they are closed to new investors.)
Delafield Fund (DEFIX) surged 30.8% in the 12 months that ended Feb. 21. It is ahead 12.5% since October 2006, when I cited it as a fund well-positioned to excel. Vanguard 500 Index (VFINX), representing the S&P 500, is up 8.5% in the same period.
Delafield is a deep-value fund that buys out-of-favor stocks it believes are poised to recover because of a catalyst such as new management, restructured operations, asset sales or some other change the rest of the market doesn't recognize.
Co-manager Vincent Sellecchia says the fund buys companies it expects to grow earnings and cash flows over two or three years, provided that the current stock price isn't reflecting that growth.
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Sellecchia says the fund finds most of its prospects among small and midsize companies, because they aren't researched by Wall Street as thoroughly as big caps. The fund's average market cap, as calculated by Morningstar, is $2.25 billion.
FBR Small Cap Fund (FBRVX), despite its name, fits comfortably into the midcap realm. It limits itself to companies with a market cap of $3 billion or below when it buys them, but it can hold them for years. Its current average cap is $3.2 billion.
Closed for more than two years, the fund reopened in January. Manager Charles T. Akre Jr. says he looks for three things: a business model that delivers above-average profits, a management both friendly to shareholders and adroit, and a strategy for reinvesting excess profits into new, equally profitable lines.
FBR Small Cap has the distinction of being in the top 1% of Morningstar's rankings of midcap growth funds over the past one, three, five and 10 years. Since inception in 1996, returns have averaged 17.9% annually.
Back in April 2002, I called Meridian Value Fund (MVALX) one of "the best mutual funds you've never heard of." Since then it has racked up average annual gains of 11.9%, compared with 6.8% for Vanguard 500 Index.
Rick Aster, the fund's founder and lead manager, describes his strategy as identifying distressed companies that have begun to show signs of revival. "We need a catalyst, and the only one we can count on for sure is earnings growth," he says.
Video on MSN Money
Video: Rethinking midcapsDavid Sowerby, Loomis Sayles chief market analyst, and market equity strategist Alec Young discuss midcap stocks with CNBC's Dylan Ratigan.
His goal is to own a company for only a year, the amount of time it takes other investors to discover one of his picks. The market doesn't always accommodate; this fund's returns were disappointing in 2004 and 2005. And Aster is no style purist; he'll venture to smaller and larger companies, though the average falls into midcap range at $7.09 billion.
But even when it struggles, the fund manages to beat the market. It has gained 17.3% over the past year.
Indexes and international stocks
I'm a fan of active management, but indexing enjoys wide appeal, and index investors have dozens of choices in the midcap space. The portfolio I would choose is an exchange-traded fund, PowerShares Dynamic Mid-Cap Growth (PWJ, news, msgs).This is one of a series of PowerShares funds that seeks to tweak the market-capitalization-weighted universe of stocks for exceptional performers, based on 10 factors the company believes produce above-average returns.
Ordinary indexes seek to monitor their entire universe, making no distinction between successful companies and also-rans. iShares Russell Mid-Cap Index (IWR, news, msgs), which fits this concept, is ahead 7% this year, as of Feb. 21, compared with the PowerShares fund's gain of 9%. Over the past year, the PowerShares fund's gain of 15.2% trumps the Russell index's advance of 14.5%.
The benign economic environment that has been so kind to equities, and especially midcaps, is global in scale, so foreign small- and midcap funds have also done very well. My choice here is T. Rowe Price International Discovery (PRIDX).
This fund, which invests primarily in small and midsize companies in developed markets, is ahead 4.9% this year, 28.2% in 12 months and an average of 25.2% per year over the past five years.
With an average market cap of $1.19 billion, International Discovery is on the line between small and midcap, but investing outside the biggest foreign stocks is still fairly fresh among mutual funds. Overseas, the two available baskets are big cap and non-big cap. International Discovery is an outstanding exponent of the latter class.
None of these funds is guaranteed to continue to deliver robust returns. Akre of FBR expects stock prices to be lower sometime in the next two years than they are now, and has more than 17% of assets in cash to await bargains. Delafield's cash horde at the end of last year was 22%.
But the global economy has defied doomsayers for years now, and even high-growth sectors like technology have begun to show strength. If you are willing to own equities, midcaps are a group you should be willing to consider. They have risks, but their owners are being compensated for taking them.
At the time of publication, Tim Middleton owned the following securities mentioned in this article: T. Rowe Price International Discovery, T. Rowe Price Mid-Cap Growth and T. Rowe Price Mid-Cap Value.
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