Why Do Mid-sized Companies Outperform Other Stocks?

The mid-cap focused FTSE 250 index has beaten both the FTSE 100 and FTSE Small Cap index over the past three, five, 10 and 15 years

Mark Preskett 20 July, 2015 | 4:07PM
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Factor investing is an investment approach targeting stocks that exhibit certain characteristics, such as value, momentum or low volatility, in order to outperform market-cap weighted benchmarks.

One of the most oft-quoted of these factor premiums is size – the historical tendency for stocks with smaller market capitalisations to outperform stocks with a larger market cap.

This can be clearly seen in the UK, where the FTSE Small Cap index excluding-investment trusts, which represents the smallest 270 companies of the 620 firms listed on the FTSE All Share, has outperformed the FTSE 100 over three, five, ten and 15 years.

However, both indices’ long-term returns have been dwarfed by the mid-cap focused FTSE 250 – which is made of the 101st to 350th largest stocks by market capitalisation.

This mid-cap outperformance can be seen overseas: in the US, where the Russell Mid Cap index beats the S&P 500 by 4.5% annualised over the past 15 years, and in Europe, where the FTSE Euromid is 3.0% ahead of the FTSE Euro 100 over 10 years on an annualised basis.

So why this dramatic outperformance of mid-caps? There are a number of factors at play here.

First, the under-researched nature of mid-caps. The largest stock by market capitalisation in the FTSE 250, as at the end of May 2015, is mobile telecoms firm Inmarsat (ISAT).

The stock is covered by 14 UK sell-side analysts, who provide research and price targets on the company for institutional clients. The coverage drops the further down the market cap scale you go. One of the index’s smaller constituents, Iron Bru maker A G Barr (BAG), is covered by just seven analysts, for example. By contrast, mega-cap stocks in the FTSE 100, such as BP (BP.) and HSBC (HSBA), are covered by more than 25 UK analysts and many more around the world.

This lack of research increases the probability of a firm beating analyst forecasts on key metrics, such as sales, cash flows or earnings. These surprises can in turn lead to sharp share price rises.

Mid-cap stocks also exhibit superior earnings growth relative to large-caps. Looking at Morningstar’s Historic Earnings Growth metric, which is calculated by averaging the previous four year’s growth rate for each stock in the index, we can see superior earnings growth in mid-caps in the UK, US and Europe.

Earnings are one of the most studied numbers in a company's financial statements as they provide a direct link to a firm’s profitability and therefore are another key determinant on its share price.

A third factor behind the mid-cap outperformance is mergers and acquisition activity (M&A). Mid-caps are often good hunting grounds for larger, cash-rich firms looking to buy growth by acquiring a smaller competitor. Mid-caps, being more mature than small-caps, are typically deemed less risky acquisition targets and the target firm is usually bought at a premium to current share prices.

And finally, there is the often-overlooked factor of index construction.

When a UK FTSE 250 firm does well, and grows its earnings, profitability and ultimately market capitalisation, it is promoted to FTSE 100. After the firm leaves the mid-cap space, any ETF or fund managed against the FTSE 250 is forced to “take profits” on the stock, locking in any gains for the investor. Profit-taking is viewed as a prudent way of managing money, and stops a manager becoming wedded to a single stock. In addition, the larger a firm grows it will inevitably see a slowing in its growth rate, however this slowing growth will be tracked by the larger-cap index rather than the FTSE 250.

Similarly, if firm performs poorly, and sees its share price fall, it will fall back into the small-cap universe, leaving the associated underperformance to weigh down small-cap index returns.

At Morningstar Investment Management, we are looking to harvest this mid-cap outperformance for client portfolios through the use of dedicated actively managed mid-cap funds.

Two of our preferred vehicles are Franklin UK Mid Cap and Old Mutual UK Mid Cap, both Silver rated funds, which have demonstrated strong outperformance of the FTSE 250.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
AG Barr PLC527.00 GBX-2.04
BP PLC466.10 GBX-0.45Rating
HSBC Holdings PLC597.20 GBX1.13Rating
Jupiter UK Mid Cap L GBP Acc3.41 GBP-0.46Rating

About Author

Mark Preskett  is a Senior Investment Consultant & Portfolio Manager for Morningstar UK                       

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