Mid-cap stocks could offer diversification, strong fundamentals in 2024

What advantages do mid-cap stocks have heading into 2024?

Brian Demain: Midcaps have meaningfully underperformed large caps [stocks] over the last several years despite reasonably strong fundamentals for a lot of midcaps. Additionally, the large-cap index has become enormously concentrated, whether it’s the S&P 500® [Index] or the large-cap growth indices, are very concentrated in the top seven names. And those are terrific businesses, but when we get into the mid-cap index [there] are companies with strong fundamentals that offer a greater level of diversification than you’d have by investing in large caps or in the broad market index at this point.

How are midcaps positioned for a potential economic slowdown?

Oftentimes, as we head into what could be an economic slowdown, small- and mid-cap stocks do tend to underperform. That plants the seeds for outperformance coming out because when the market acknowledges that the Fed [Federal Reserve] is done and the next move is a rate cut, that’s ultimately stimulative. The market is forward-looking, and that’s generally going to be positive for small- and mid-cap stocks.

What long-term growth themes are you watching in midcaps?

One really overriding theme is the electrification of the economy. We see this as a 20- or 30-year powerful investment theme to meet some of the climate goals aligned with government stimulus and aligned with the unit economics of things like electric vehicles and heat pumps and the like. We just see electrification as a very long-term trend. That can manifest in different areas of the market, whether it be regulated utilities, whether it be semiconductors selling to electric vehicles, whether it be other types of components suppliers. So, there are a lot of ways to have exposure to that theme, but that’s one we’re very excited about.

Another area we’re excited about that I think is somewhat unique in the mid-cap space is the opportunity to invest with great capital allocators. The last 10, 15 years when the cost of capital has been exceptionally low, we’ve had a lot of private capital looking at acquiring assets and the like. Now, with a real cost of capital, we think management teams that are exceptionally prudent at allocating shareholder capital are going to have great opportunities to buy small- or medium-size businesses and consolidate them into their platforms and really create a lot of value for shareholders. So, that’s another area we’re excited about in 2024.

What is the biggest risk to midcaps now?

Within the mid-cap growth space, which is where we focus, probably the biggest risk we see is extreme valuations of the most expensive names in the benchmark. One of the metrics we look at is the percentage of the benchmark trading at north of 40x earnings. Historically, that number has been around 10% for the benchmark. When the market got really ebullient in 2021, that number grew as high as 50% in the Russell Midcap Growth¹ benchmark, which is really an exceptionally high number. It’s corrected down from that, but it remains pretty elevated at 35%. So, we think as mid-cap growth investors, one of the risks we need to be aware of is not paying too much for growth companies. We want to remain true to our process of finding great, growing competitively advantaged businesses, but it’s very important to be aware of the valuations we’re paying for those stocks.

What’s the key takeaway for mid-cap investors in 2024?

Historically, midcaps have been a phenomenal area of the market from a capital appreciation point of view. They’ve tended to outperform both small- and large caps over very long periods of time. We think against that backdrop we’re at a reasonable starting place for mid-cap stocks given their recent underperformance vs. large caps and the attractive valuations that we see in the space. We do think it’s an important time to be deliberate about which stocks one invests in in the mid-cap space given some of the valuation risks at the extremes of the market, but a well-constructed portfolio of midcaps, we think, is a pretty attractive place to be on a multiyear basis.

¹ The Russell Midcap^® Growth Index measures the performance of the mid-cap growth segment of the US equity universe. It includes those Russell Midcap Index companies with relatively higher price-to-book ratios, higher forecast medium-term (2 year) growth, and higher sales per share historical growth (5 years).