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The Dynamic Middle?
What, exactly, is a mid-cap stock?
While traders think they know the answer to this simple question, very few of their answers -- at least in my experience -- can withstand much scrutiny.
And, yet, it’s crucial that we be very clear about what a mid-cap is because this sector of the market has become the new darling among a number of advisers.
Earlier this year, Standard and Poor’s declared “mid-caps [now] represent the ‘sweet spot’ of the U.S. equity market.” And, so far, at least, this advice has been on target with the SPDR Midcap ETF (TICKER:MDY), an index fund that is benchmarked to the S&P Midcap 400 Index, far outpacing the Dow Jones Industrial Average.
Mid-caps get their identity from being neither large nor small, of course. In other words, they have no inherent distinctiveness on their own; their identity comes from not being something else. That doesn't mean that all mid-caps are alike, however. And, it is that sleight of hand that, I’m afraid, many investors are making.
Consider the accompanying table, which lists the 10 stocks that currently represent the biggest holdings in the MDY, the SPDR benchmarked to the S&P Midcap 400 Index. (The stocks are listed in order of their percentage weight in the index.)
Company |
P/E ratio |
Price/Book Ratio |
Dividend Yield |
Cognizant Technology Solutions Corp. (TICKER:CTSH) |
61 |
12.6 |
n/a |
Peabody Energy Corp. (TICKER:BTU) |
18 |
4.6 |
0.6 percent |
Expeditors Int’l of Washington (TICKER:EXPD) |
43 |
9.6 |
0.5 percent |
Precision Castparts Corp. (TICKER:PCP) |
26 |
5.0 |
0.1 percent |
Noble Energy Inc. (TICKER:NBL) |
14 |
2.4 |
0.5 percent |
CH Robinson Worldwide Inc. (TICKER:CHRW) |
36 |
10.3 |
1.3 percent |
Fidelity Nat’l Financial Inc. (TICKER:FNF) |
10 |
1.6 |
5.0 percent |
Questar Corp. (TICKER:STR) |
16 |
3.2 |
1.2 percent |
Microchip Technology Inc. (TICKER:MCHP) |
26 |
4.2 |
3.0 percent |
Varian Medical Systems Inc. (TICKER:VAR) |
26 |
8.0 |
n/a |
If you can find a common pattern in the valuation ratios of these companies, you are better at pattern recognition than I am. And, yet, all of them will get bought en masse by investors taking the advice to buy mid-cap stocks.
To be sure, I’m probably being too harsh on advisers for putting stocks of widely varying characteristics into the same basket. We have no choice, when trying to make sense of an otherwise chaotic world, but to employ some form of classification and categorization.
Nonetheless, this categorization process has profound consequences for the prices of various stocks. Consider a study that appeared in 2003 in the Journal of Financial Economics called "Style Investing", by Yale finance professor Nicholas Barberis and Harvard finance professor Andrei Shleifer. They found that the stocks that investors put into a category begin to be more highly correlated with each other than they would be otherwise. This co-movement causes some stocks to become vastly overvalued and others to become quite undervalued.
Applying the Barberis / Shleifer theory to mid-caps, this means that mid-cap stocks co-move with each other to a greater extent than is justified by their fundamentals. Much more than they would otherwise, both high P/E and low P / E mid-caps will rise and fall together.
You might think this over-valuing / undervaluing that results in co-movement is a crazy thing for investors to do, but a far better response would be to see the opportunities the process creates. If unwitting investors want to bid overvalued stocks up to even greater overvaluation, then that simply provides the rest of us with wonderful short-sale opportunities.
That’s certainly something to think about the next time your adviser recommends you invest in mid-cap stocks.
To read the study that appeared in 2003 in the Journal of Financial Economics called "Style Investing", click here.
Mark can be contacted via email at mhulbert@marketwatch.com.
