There was a great chart in a recent Goldman Sachs Group Inc. report that got me wondering whether medium-size companies might have superpowers. Here’s my adaptation of the original graphic1:
The chart shows that mid-cap stocks have delivered meaningfully better cumulative returns than both the S&P 500 and small-cap stocks over the past three decades. For the mid-caps, that works out to a compound annual growth rate of more than 12%, compared with roughly 11% for the large-caps. That difference adds up over time. If you invested $100,000 in mid-caps at the end of 1994, for instance, you’d have about $3 million today — about $700,000 more than you’d have by just investing in the S&P 500. Which begs the question: Why aren’t people putting their entire equity portfolio into this stuff?
Digging a little deeper, I found that there’s indeed something to this. But predictably, there are major caveats.
As it turns out, mid-caps are the tortoise in the Tortoise and the Hare fable, and that’s borne out by both the index’s composition and the historical record. Industrials, financials and consumer discretionary shares get the biggest sector weighting in the mid-cap index (23%, 18% and 14%, respectively) while the S&P 500 is famously dominated by high-flying information technology (32%). The leading contributors to the S&P 500’s recent success are at the forefront of artificial intelligence, while the top-performing mid-caps this year include Sprouts Farmers Market Inc. and Comfort Systems USA Inc., a provider of heating and air conditioning systems.
This tilt toward steady-as-she-goes “old economy” industries makes some sense. Fast-growing and innovative juggernauts never last long as small- or mid-cap stocks; under index rules, they graduate into the big leagues when they exceed $18 billion in market capitalization. That’s partly why the S&P Midcap 400 has far less overall concentration. Its 10 biggest companies constitute less than 7% of the index, while the 10 biggest large-caps are about 37% of the S&P 500.
The market-capitalization-weighted S&P 500 operates something like a momentum trade in which the winners take up larger and larger weightings, while the losers shrink and drop out of the index. Momentum trades can do extraordinarily well when they’re working, but they can also lead to spectacular blowups.
What has all of this meant for performance? On a relative basis, mid-caps shined during the deflating of the dot-com bubble and the early days of the recovery (2000-2005). In 1999, the index was a bit more techy and concentrated than it is today, but still much less so than the S&P 500 at the time. Not only did mid-caps cruise through 2000 with an 18% return, but they posted only modest losses during the subsequent down years and exceptional gains during the bounce-back period. From 2000-2005, mid-caps were hands down the best place to be — not only better than the S&P 500, but also outperforming small-caps and the equal-weighted version of the large-cap gauge. That resilience to the internet bust ended up explaining the vast majority of mid-caps’ outperformance over the decades.
Unfortunately, those golden years have yet to be replicated to any meaningful degree, and that explains why they aren’t more popular, despite the findings in the first chart. Mid-caps have underperformed the S&P 500 in eight of the past 10 years. The best way to deliver an underwhelming performance in that period was to forgo investing in the superstar growth stocks known as the Magnificent 7, which includes Alphabet Inc., Amazon.com Inc., Apple Inc., Meta Platforms Inc., Microsoft Corp., Nvidia Corp. and Tesla Inc. An all-in bet on mid-caps was effectively a decision to do just that.
The million-dollar question is whether we’re heading for another period akin to the dot-com bust (or even just a broad-based correction for the stocks swept up in the artificial intelligence theme). As I noted last month, hype around AI is bound to ebb and flow, even if it really is the revolutionary technology that people say it is. The path from the advent of a new technology to widespread adoption and profitability is rarely a direct one, with bumps and bankruptcies along the way. Meanwhile, the profit outlooks for the Magnificent 7 growth stocks, however impressive, aren’t quite as mind-blowing as they used to be, even though their rich valuations don’t show it.
In their Nov. 18 strategy note looking ahead to 2025, Goldman Sachs strategists led by David Kostin said that the Magnificent 7 would probably continue to outperform, yet they also recommended that investors “seek opportunities in mid-cap equities.” Here’s how they put it:
Mid-cap equities are expected to grow earnings more rapidly than the S&P 500, have higher quality attributes compared with small-caps, and have typically generated positive returns as long as the US economy is expanding. Valuations for mid-caps also still appear attractive today...
At some point, the S&P 500 could be in for a vicious correction, and the S&P Midcap 400 might be a decent place to seek some refuge. With its more modest valuations and less concentration risk, it might not be a terrible idea to sprinkle a mid-cap fund into broader equity portfolios. But I sure wouldn’t abandon the large-caps completely; they still have the hot hand and figuring out when their streak will end could be devilishly hard.
1The main difference between my chart and Goldman's is I show three decades of total returns instead of four, but the takeaway is the same: Mid-caps outperformed in the long run.
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