Mid-cap stocks: The investment sweet spot

You might call mid caps the investment sweet spot. Medium-sized companies are small and nimble enough to post exciting growth when the going is good, but large enough to show resilience when times get tougher. No wonder investors have flocked to this part of the stockmarket during the turbulence of the past few years.

The rewards for doing so are still evident, with middle-ranking stocks outperforming during the first two-thirds of 2013. The FTSE Mid 250 index was up 16% by the end of August, compared with just 6.4% from the FTSE 100 (UKX).

That is what one would expect, since the conventional investment wisdom is that mid-cap stocks outperform during periods of improvement in the economy, particularly when economies emerge from recession, as they are now. The flip-side, the argument goes, is that blue chips are a better place to be during more difficult economic periods.

However, the long-term performance statistics for mid-caps are impressive too. Over 10 years to the end of 2012 - a period spanning the financial crisis and subsequent recession - the FTSE 250 returned around 150%, more than three times the 45% or so achieved by the blue-chip benchmark.

A Goldman Sachs study of mid-cap performance in the US tells a similar story. Mid-cap stocks there achieved average annual returns of 10.28% over 20 years to the end of last year. Not only was that better than large-cap returns, which averaged 8.34% a year, but it also outperformed supposedly high-growth small-cap stocks, which returned 8.42% over the year.

Moreover, Goldman Sachs also found that the mid-cap stocks were substantially less volatile than small caps during the period and only marginally more volatile than the large-cap universe. Their risk-adjusted returns were streets ahead.

So what underpins this outperformance, and - crucially - will it continue?

"I think this can be explained by a number of factors, but the sector breakdown is one of them," says Mike Horseman, managing director at independent financial adviser Cockburn Lucas. "Essentially, you are getting exposure to younger, more dynamic, growing companies; they may have higher volatility at times, but that's the deal, as clearly you're taking on more risk."

Horseman points out that smaller companies have more room to grow than their larger peers, since they're starting from a lower base. It is easier for a company worth less than £500 million, as the smaller constituents of the FTSE 250 are, to move quickly and expand rapidly than it is for a company already valued at £2.5 billion, the threshold for FTSE 100 entry.

However, mid caps have other advantages, not least the merit that they offer much better diversification opportunities than the biggest companies. The FTSE 100 is dominated by natural resources companies, which account for almost a third of the index, and financials, which make up a further 25%. In contrast, the FTSE 250 is spread much more evenly across the full range of stockmarket sectors.

Theme adaptable

At the same time, because individual mid-cap companies are smaller and therefore less diversified in their trading activities, they offer more direct exposure if there are particular investment themes you favour. A good current example is the housebuilding sector, where FTSE 250 stocks, including Bovis Homes, Berkeley Group and Redrow, have all benefited from the positives driving the sector forward.

"At a sector level, housebuilders have been our biggest theme for some time," says Martin Hudson, co-manager of the mid-cap specialist Mercantile Investment Trust. "There is a great deal of government stimulus, as there is a clear economic need to build more houses as well as a clear lack of new homes in relation to the rate of new household formation."

Active fund managers such as Hudson also relish another opportunity the mid-cap universe throws up: the possibility of uncovering hidden gems. FTSE 100 companies are scrutinised minutely by analysts, shareholders, journalists and all sorts of other interested parties. FTSE 250 companies attract less attention. As a result, you're more likely to come across information that other investors have yet to pick up on.

Then there's the mergers and acquisitions factor. Historically, there have been far more deals involving mid-cap companies than their larger peers - unsurprisingly, given the unwieldy nature of transactions between the biggest businesses. While corporate activity has been modest since the financial crisis across all sectors of the stockmarket, deal volumes have now begun to pick up. And with so many companies, in the UK and beyond, holding large amounts of cash on their balance sheets, more medium-sized companies are likely to attract bids if the economic recovery continues and confidence strengthens.

Above all, it is the more cyclical and domestic nature of so many mid-cap stocks that has delivered the market-beating returns of recent years. While the FTSE 100 is stuffed with multinational businesses, mid-cap stocks are much less globally oriented, earning more than half their revenues at home. They're also much more sensitive to the economic cycle, with sectors such as housebuilding, retail, and manufacturing well represented.

"This is why mid-caps have done so well in the past decade," says Darius McDermott, managing director at IFA Chelsea Financial Services. "They underperform their large-cap peers in falling markets but more than make up for it in rising markets."

McDermott believes mid-caps continue to be well placed to benefit from an improving economy and points out that many weaker businesses have been knocked out by the difficult years that followed the credit crunch. "The survivors will be stronger and will have gained market share," he says.