This May Be the Sweet Spot of the Stock Market

Investors should have a decent chunk of stocks in their portfolios to fuel long-term growth. But after a disquieting two years in which equities bounced around a lot — punctuated by two scary slides and now a record-breaking rally — the question is: What kind of stocks?

There’s a solid argument that mid-sized stocks offer the best prospects over time.

To their fans, "mid-caps" — shares of medium-sized companies with a market capitalization, or value, between $2 billion and $10 billion — are the sweet spot of stock investing, providing some of the stability of big blue chips along with some of the turbo boost that small-company shares can offer.

Over the past 20 years, the Russell mid-cap index posted an average annual return of 10.5%, vs. 8.5% for the Russell 1000 large-stock index and 8.3% for the Russell 2000 small-stock index, according to the research firm Morningstar. Mid-cap outperformance held true over the past 10 and 15 years as well.

To be sure, the past one, three, and five years haven't been as kind. Over the past five years, for instance, large-caps edged ahead of mid-caps, 12.2% to 11.5%. Perhaps the seemingly greater stability of giant companies amid turbulence, like when crashing oil prices keelhauled the energy and commodities sectors, have made the difference there.

Yet the potential for a recovery in long-suffering oil and commodities is another reason to pay attention to mid-cap stocks.

Flying under the radar

For whatever reason, mid-caps' superior long-term returns are not well-known. Mid-caps as a class get relatively little public or Wall Street attention, compared to bigger stocks. “They’re the Rodney Dangerfield of investments,” says Brian Angerame, a managing director at ClearBridge Investments, a Legg Mason unit that sponsors two mid-cap funds. “They get no respect.”

Mid-caps receive less coverage from investment analysts than large-caps do. Example: Bloomberg says that Idexx Laboratories , which makes diagnostic equipment for veterinarians and has a $8.8 billion market cap, is followed by 10 analysts. But giant drugmaker Pfizer , sporting a $228 billion market value, has 28 analysts.

The case for mid-caps

To their proponents, mid-cap companies shine because they are more nimble than behemoths, while having the financial resources to withstand troubles that can capsize smaller businesses. It's like Goldilocks' happy discovery about which of the three bears' bowls of porridge is just right.

“Mid-caps don’t have the bureaucracy and red tape of the big companies, so they can make quick decisions,” says Brian Peery, co-manager of the Hennessy Cornerstone Mid Cap 30 fund . “And if you add a few million to the revenue of Microsoft, it will have little impact on the bottom line. That’s not true for mid-caps.”

Another plus: The most successful mid-size companies are often poised to graduate into the large-cap realm, which means a nice run-up for their stocks if they rise into blue-chip status.

That’s the hope surrounding one of Peery’s key holdings, JetBlue Airways , whose share price has almost doubled over the past two years amid surging earnings. The $5.6 billion airline started out as a low-cost carrier and now is expanding its high-end Mint service, which should plump profits further. It also is adding destinations.

What’s more, mid-caps tend to have better risk-adjusted performance than bigger and smaller stocks over the long haul. There's a statistical measure used on Wall Street called the Sharpe ratio, which gauges risk-adjusted returns. Over the past 20 years, mid-caps sported the highest Sharpe ratio among domestic equities.

And mid-caps have smaller overseas exposure than large-caps, an advantage nowadays thanks to the strong dollar. When the buck is gaining strength as U.S. multinational corporations are translating foreign profits back into U.S. dollars, the take is smaller.

The risks when it comes to mid-caps

Nevertheless, larger economic forces can buffet mid-caps more forcefully than the mega-companies. Over the past year, price crashes in the commodities realm, especially energy, have slowed mid-cap earnings growth. Oil and gas exploration company Chesapeake Energy , which has a $3.8 billion market cap, has seen its stock price halved over the past 12 months as its net income cascaded into the red.

The energy and materials (such as chemicals) sectors make up 12% of the Russell mid-cap index. “Mid-caps have taken it on the chin” as a result, says ClearBridge’s Angerame.

This situation has led to a remarkable reversal of fortune in overall mid-cap earnings growth. While the energy/commodities slump has hurt earnings for companies of all sizes, mid-caps have suffered the most. As of mid-year 2015, Russell mid-cap earnings growth led those of large and small companies, Morningstar finds. Now it is the laggard.

Even if the earnings slide is temporary — energy and many other commodities seem to be regaining their footing, to a degree — investors face a challenge finding the right mid-cap fund to go with.

Over the past 20 years, when the Russell index posted an average 9.9% annual increase, mid-cap funds trailed that by about 1.5 percentage points. That gap holds true for more recent periods, as well.

A likely reason is that over 90% of mid-cap funds are actively managed — meaning they are run by traditional stock pickers. And a majority of active funds fail to do better than their benchmark, year in, year out.

Finally, the picture gets muddied when you try to judge what exactly is a mid-cap fund, making side-by-side comparisons more difficult.

A study by investment consulting firm Multnomah Group, for the five years ending in 2010, demonstrates that large-cap and small-cap funds have at least a third of their holdings in mid-cap stocks. Some of them seem to be mid-cap-oriented, but aren't really. The firm’s Scott Cameron says the picture is little changed today.

For investors wishing to give mid-caps a try, buying a low-cost index fund that simply tracks a mid-cap benchmark might make sense. For instance, iShares Russell Mid-Cap ETF , tracks the Russell mid-cap index. You can also try iShares Core S&P Mid-Cap ETF , which tracks the S&P 400 mid-cap stock index and is in the Money 50, our recommended list of mutual and exchange-traded funds.

Some actively managed funds have shown an ability over time to beat the benchmarks, like Hennessy Focus and T. Rowe Price Diversified Mid Cap Growth Fund , which is also in the Money 50.

No guarantee exists that mid-caps’ rep as the investing sweet spot will be deserved going forward. Still, this is one corner of the investing world worth a good look.