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Of Mutual Interest

Mid-cap stocks are getting some love, finally

NEW YORK — Maybe the middle child really should be the favorite.

Just like families sometimes overlook the middle kid, investors all too often pay attention to just the smallest and largest stocks. Managers of mid-cap stock mutual funds say they've experienced the middle-child syndrome for years: Small-caps are young companies that offer the thrill of big growth, the thinking goes, while large-cap companies have well-established brands and can be more dependable.

But it's the middle ones that have delivered the best results over the last generation, at least when it comes to stocks. Managers say that's because the stocks of mid-cap companies can offer the best attributes of both larger and smaller ones. Investors are now noticing the strong performance, and they poured more money into mid-cap stock funds last year than either large- or small-cap funds. The trend weakened early this year, but mid-cap stock funds again attracted the most money last month, according to data from Morningstar.

"It really does represent the sweet spot," says Mariana Connelly, a client portfolio manager at J.P. Morgan Asset Management. "Unlike small caps, these companies are a little more seasoned and not quite as volatile. Unlike large caps, they have a lot of room to grow."

Different indexes vary on what defines a mid-cap company, but they generally have market values closer to $4 billion than the $467 billion value of Apple.

The biggest stocks in the S&P 400 MidCap index include $8.8 billion Advance Auto Parts (NYSE: AAP) and $9.5 billion Church & Dwight (NYSE: CHD), which sells Arm & Hammer baking soda and Trojan condoms. The Russell Midcap index includes larger companies, such as $28.5 billion Delta Air Lines (NYSE: DAL). The average company in the large-cap Standard & Poor's 500 index is worth $35.4 billion.

Over the last 20 years, mid-cap stocks in the S&P 400 have returned 12.4 percent annually, including dividends. That beats the 11.2 percent annual return of the S&P 600 SmallCap index and the 9.5 percent annual return of the large-cap S&P 500 index.

Investors may already own mid-cap stocks without knowing it, particularly if they have a broad-market stock fund. The largest fund, Vanguard's Total Stock Market Index fund, owns stocks of every size in its attempt to match the entire market's performance, for example. Some funds dedicated to large-cap stocks, also "reach down" and own mid-cap stocks, while some small-cap stock funds "reach up."

To be sure, the rising popularity of mid-cap stocks has helped make them more expensive than they used to be. Stocks in the S&P 400 trade at 19.7 times their earnings per share over the last 12 months. That's well above the average price-earnings ratio of the index over the last 10 years of 16.4. Fund managers agree that mid-cap stocks are no longer cheap -- the S&P 400's price-earnings ratio dropped close to 8 during the financial crisis -- but they say more gains are still possible.

Among the attributes they cite are:

Stronger earnings growth than large caps.

Big companies are in the midst of a relatively poor earnings season: Analysts say profit for S&P 500 companies fell 1.4 percent in the first quarter from a year ago, according to FactSet.

The picture is brighter for mid-cap stocks. Analysts are forecasting growth of 1.7 percent, and Wall Street expects the trend to continue as long as the economy keeps improving. It's easier for mid-sized companies to find new products or markets that make meaningful contributions to their bottom lines, says Bryant VanCronkhite. He is a portfolio manager at Wells Fargo Advantage Special Mid Cap Value fund.

"It's hard to grow when you're a $50 billion, $60 billion company," he says. Big companies can buy other businesses to drive growth. But they need to buy a large-enough company to significantly boost their revenue, and large deals come with more risks, VanCronkhite says.

More of a domestic focus than large-cap stocks.

The U.S. economy's growth isn't as strong as many would like, but it's still better than that of many other countries. When the International Monetary Fund said last month that it expects global economic growth to accelerate in 2014 and 2015, it cited the United States as a main reason.

That's important for mid-cap companies because they tend to get more of their revenue from the United States than large-cap companies, says J.P. Morgan's Connelly. She points to the financial sector. Mega banks do business all over the world, while mid-cap regional banks tend to focus on loans and deposits in their home regions.

Not as expensive as small-cap stocks.

Mid-cap stocks look expensive relative to their earnings, but small-cap stocks look more so. The S&P 400 trades at 19.7 times its earnings per share over the last 12 months, which is below the small-cap index's ratio of 20.6.

Small-cap stocks are also currently more expensive relative to their own 10-year history than mid-cap stocks.

A somewhat smoother ride than small-cap stocks.

Mid-cap stocks have offered a slightly softer landing than small-cap stocks in market downturns. After the Great Recession began in December 2007, the S&P 400 MidCap index lost 53 percent by the time the market bottomed. That was a touch milder than the 54.4 percent loss for small-cap stocks.

The last time the market had a drop of at least 10 percent -- something traders call a "correction" -- mid-cap stocks fell 24.6 percent. That was between July and October 2011, when worries flared about Europe's debt crisis and the downgrade of the U.S. credit rating. The S&P 600 SmallCap index fell 25.5 percent over the same time.

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