Return of Mid-Caps?
With 2018 in the books, many investors have had time to reflect on a year in which almost every asset class (outside of cash and short term USTs) had a negative total return. The S&P 500, a market cap weighted index of the largest 505 stocks, fell 4.39% in 2018 while the equal weighted S&P 500 index fell 7.65%. This extra 326bps is a result of some of the largest US stocks outperforming the index (Amazon, Microsoft, and Google among others). Point being, if you missed out on these stocks your return was likely a lot worse than what’s indicated by the S&P 500.
Digging deeper beyond the S&P 500, we find that mid-cap stocks (as represented by the S&P Midcap 400 Index) fell 11.1% in 2018. From 2017–2018, the mid-cap index returned just 3.33% versus 16.47% for the S&P 500 and 9.80% for the S&P 500 equal weighted index. So, larger stocks have outperformed smaller stocks, but the very largest US stocks have accounted for the majority of the gains the last two calendar years. Now from a valuation perspective, what does this say about mid-cap stocks versus their large cap counterparts?
As shown from the chart above, for the first time since early 2009, the mid-cap index is trading at a cheaper price to earnings multiple than the S&P 500. Typically mid-cap stocks trade at a premium due to their higher growth rates.
On a price to cash flow basis, the same conclusion is made with the mid-cap index trading below the S&P 500. As the S&P 500 is market cap weighted, the larger technology companies have seen margins and cash flows increase driving some of this dispersion. Nevertheless, the price to cash flow multiple is still historically high for the S&P 500 and quite low for the mid-cap index.
Is this apples to apples?
A good question is what does the S&P 400 mid-cap index look like compared to the S&P 500? As shown below, the sector weightings are dramatically different between the two indices. In particular, a much larger weighting exists for industrials, real estate, materials, and financials in the mid-cap index. On the flip side, health care and information technology (two sectors with strong trailing returns) both have a smaller allocation.
As noted above, the difference in weightings is notable as the highest performing segments in the S&P 500 are weighted lower in the mid cap index, while the highest weighting segments of the mid-cap index have been some of the biggest laggards including financials and industrials.
There’s an old adage that the best time to buy cyclicals is when they’re expensive and sell them when they’re cheap. There might be some validity to this saying, but the fact remains that cyclicals have never been cheaper compared to the S&P 500 index.
Is there an opportunity here?
All else equal, mid-cap stocks appear to have a strong set up to outperform their larger peers over the coming years. Current fears around oil prices, future bank profitability, and forward earnings of cyclical stocks are all weighing on the underlying companies in the mid-cap stock index. There’s promise for a recovery and change in sentiment for each of these segments. Further, on a relative basis, the out-performance we’ve seen from the largest market cap weighted stocks may disappear in the future creating a drag instead of a tailwind. I believe the current valuations are compelling, and we will see this segment of the market outperform.