High Quality Mid Caps Enjoy Performance Advantage

Why Quality Matters in Mid Cap Investing

Key Takeaways

• The quality premium well documented among large cap stocks is also applicable to mid-cap companies, with high-quality mid caps enjoying long-term performance advantages versus their low-quality peers.

• The mid-cap quality premium has been most significant during periods of market transition such as rising interest rate environments

• As fundamental factors regain influence, companies possessing quality characteristics of high returns on capital, high free cash flow and strong balance sheets, are positioned to thrive.

Why Quality Matters for Mid Caps

We believe mid-cap stocks, especially those with strong quality characteristics, offer superior absolute and relative return potential for investors who are forming allocation strategies in a period of transition for the market and economy. The economic recovery continues to be exemplified by moderate growth and an improving job market. But the durability of the current expansion – which at 57 months is now the seventh longest in history and far longer than the average expansion of 39 months – is the subject of much debate. In response to this improving economic growth, the Federal Reserve is well into its taper of bond purchases, marking the end of its latest round of unprecedented monetary stimulus. The taper may also be pointing to a top in bond prices and a bottom for bond yields and interest rates. Meanwhile, the current bull market for U.S. equities – partially fueled by abundant liquidity – is nearing five and a half years, about the average length for bull markets dating back to the 1930s. The market’s appetite for risk has risen, while volatility has fallen. As sanguine as we are about the prospects for the current bull market, we recognize that all things must come to an end.

Considering these factors along with a high level of current geopolitical discord, it is not outlandish to imagine a shift in priorities by the market as a whole. More specifically, we may be on the cusp of an equity market driven by fundamentals rather than low interest rates and liquidity – more so than at any time since the onset of the financial crisis. The unwinding of Fed support unparalleled in its size and duration, combined with a return to more normal (and volatile) market conditions, will likely lead to a market that judges companies on their own fundamental merits, heightening the need for profitability, free cash flow and strong balance sheets, all elements of high-quality mid caps.

Long-Term Outperformance

The performance edge of mid caps has been well documented and dedicated exposure to the asset class can leverage this advantage. Mid caps, as defined by the Russell MidCap Index, have produced higher risk-adjusted returns since 1979 (Figure 1). In addition, mid caps have consistently higher Sharpe ratios than both large caps and small caps over the last 25 years. Mid caps have also outperformed large caps in positive markets and offered nearly the same degree of downside protection during negative periods.

Current conditions are particularly supportive of mid caps. For starters, profit margins have room for improvement. While the 14.1% operating margin of the S&P 500 is well above its 20-year average of 12.1%, the 9.3% operating margin of the S&P MidCap 400 remains below its historical mean of 9.7%. We think it is possible for profit margins among mid-cap companies to approach historical highs as they continue to grow and innovate. At the same time, mid caps derive more of their revenue and profit from a domestic economy that has less risk than the global economy upon which multinational large caps depend. Lastly, the financial strength and growth characteristics of mid-cap stocks make them attractive acquisition targets. Overshadowed by recent media reports highlighting the increase in merger and acquisition activity, the rate at which mid-cap stocks have been receiving offers is roughly half its historical average, according to Morgan Stanley. We expect that low interest rates and record levels of cash on large cap balance sheets will lead to increased M&A activity involving mid caps.

Quality Matters in All Market Conditions

A less apparent but equally important characteristic when considering mid caps is quality. Numerous studies have documented the long-term advantages offered by high-quality large cap stocks, particularly during market downturns. Few have examined the importance of quality in relation to mid-cap investment returns. Historical comparisons of high-quality versus low-quality mid-cap stocks illustrate that fundamental factors lead to performance differences over time. Dividing the universe of mid-cap stocks into high-quality, neutral and low-quality segments, high-quality mid caps have outperformed low-quality mid caps by an average of 670 basis points per year since 1965. For the purposes of this study, stocks with market capitalizations between $1 billion and $10 billion were divided into deciles based on three fundamental “quality” characteristics: free cash flow yield, return on equity and net debt-to-capital ratios. The mid-cap universe was rebalanced into deciles based on these characteristics over various holding periods ranging from one month to five years.

High-quality mid caps have been consistent outperformers versus low-quality mid caps across most time periods and market conditions. Examined over rolling five-year time periods going back to 1965, high-quality mid caps have outperformed their low-quality counterparts by an average of 16.4 percentage points (Figure 2). They have also delivered superior returns in each of the last four decade periods through 2009 (Figure 3). In the most recent period from March 2009 through July 2014 marked by aggressive monetary easing and abundant liquidity, high-quality mid caps have trailed low-quality mid caps. During this period, the market slowly recovered from the financial crisis and often rewarded companies with the lowest returns on equity, the most debt-laden balance sheets, and little or no earnings. We expect that as easy money conditions reverse and the economy normalizes, what has been a tailwind for lower-quality companies will become a headwind.

Quality differences are most apparent during transitional periods in market cycles. In recessionary periods over the last 50 years, high-quality mid caps have outperformed their low-quality counterparts by an average of 11 full percentage points per year (Figure 4). This makes sense as high-quality companies are partially insulated by their ability to internally generate profits and cash flow to sustain or expand business operations during periods of market or economic distress. Low-quality companies, meanwhile, may be forced to rely on outside financing to get through difficult periods, increasing their cost of capital and forcing them to allocate more of their income to debt service. The persistent profitability of high-quality mid caps through downturns also makes them attractive to investors who may purchase shares of these companies during a “flight to quality,” providing support to their stock prices.

High-quality mid caps leverage their financial strength in positive market environments as well by continually reinvesting in their businesses to support growth and innovation. During periods of economic expansion since 1965, high quality has outperformed low quality by an annual average of 600 basis points. Disciplined capital allocation to research and development helps contribute to higher estimated 3- to 5-year earnings per share growth rates of mid caps compared to large caps and enables emerging leaders to maintain and expand their competitive advantages in the markets they serve.

Quality Holds Up As Rates Rise

For investors concerned about the risks posed by an environment of rising interest rates – a likely scenario for the U.S. economy should the current recovery continue to progress – mid-cap stocks have demonstrated resilience over such periods. Mid-cap returns are inversely correlated to bond prices and the asset class has delivered higher excess returns compared to large caps during rate spikes. Earnings of mid-cap companies are more tied to the U.S. economy than those of large caps so higher interest rates resulting from stronger economic growth could also portend better future earnings for mid caps.

Not only have mid-cap stocks done well during periods in which interest rates were rising, but high-quality companies have outperformed low-quality ones during these periods. Segmenting the universe by quality and using the 10-year U.S. Treasury yield as a proxy for interest rates, high-quality mid caps have delivered positive performance in most periods of rising yields since 1965 while low-quality stocks have mostly posted losses in these instances. Figure 5 not only highlights that high quality can perform well during secular rising rate environments such as the 1970s, but also during cyclical interest rate jumps such as witnessed from 1983-85, 1988-89, 1994-95 and 2003-07.

Seeking Out Quality

At ClearBridge Investments, we define quality companies as possessing a combination of financial strength, disciplined management and sustainable competitive advantages. In searching for high-quality companies to own, we seek those that exhibit high returns on capital, strong and predictable free cash flow, and balance sheets capable of supporting business operation during recessions – even those as disruptive as the financial crisis. Our use of quantitative tools that screen for these quality metrics allows us to focus our fundamental research efforts and build our portfolios from the bottom up, with only our most high-conviction, high-quality ideas.

We believe a rigorous portfolio construction process, guided by a quality orientation, provides distinct advantages over passive mid-cap exposure. By taking an active approach to stock selection, we can eliminate from consideration low-quality companies that are competitively disadvantaged, too capital intensive, expensively valued, have too much debt, or generate poor returns on capital. An investor who currently owns mid-cap stocks through a passive ETF benchmarked to the Russell MidCap Index, on the other hand, is exposed to a basket of companies of which many are unprofitable, generate no free cash flow, have poor returns on capital and carry significant leverage (Figure 6). We believe that careful selection of high-quality companies enables an active manager to create value. So too does the purposeful avoidance of these weaker companies.

Conclusion

For investors concerned that the current economic, equity, and interest rate cycles are approaching an inflection point, we believe high-quality mid-cap stocks should be part of an asset allocation solution. Since 1965, high-quality mid-cap stocks have outperformed their low-quality peers by a meaningful margin. Observing this performance history, we believe that high-quality mid-cap stocks have the fundamental strength, cash flow and access to capital to not only survive, but thrive in an environment characterized by uneven economic growth, rising interest rates and volatile equity markets.

Portfolio Management Team

Brian Angerame

Managing Director, Portfolio Manager Joined a predecessor firm in 2000 BA in Government from Dartmouth College

Derek Deutsch, CFA

Managing Director, Portfolio Manager 15 years of investment industry experience Joined a predecessor firm in 1999 MBA from Georgetown University BA from Brown University

Past performance is no guarantee of future results.

Copyright © 2014 ClearBridge Investments.

The opinions and views expressed herein are of the ClearBridge Investments, LLC Mid Cap portfolio management team as of the date shown, and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.

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