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5 things you should know about mid-cap stocks

BOSTON — The best-performing part of your stock portfolio may there by accident.

Investors tend to dwell on how their small company stocks, or small-caps, are faring versus their large-caps. They often overlook mid-caps, the stocks occupying the space between the two extremes, with market values in the $1 billion to $10 billion range.

“If they’ve still got cash left over, then maybe they allocate some to mid-cap,” says Brian Lazorishak, co-manager of the Chase Mid-Cap Growth Fund (CHAMX).

Mid-caps are sort of a happy medium. It’s rare for them to outperform small-caps in a rally, because small companies typically reinvest their profits to fuel their growth, and they’re more nimble than larger operations. But large-caps do better when the market skids, and size and stability provide cushion.

Investors often adjust their portfolios using that big-vs.-small mindset, for better or worse.

“They tend to wax and wane between euphoria and despair, optimism and pessimism,” says Jim Grefenstette, co-manager of the Federated Mid Cap Growth Strategies Fund (FGSAX).

Stocks have been choppy lately, and it’s mid-caps that have been beating the market. The Standard & Poor’s MidCap 400 index is up 5.5 percent this year, compared with 4.9 percent for the large-cap S&P 500 and 4.3 percent for the S&P SmallCap 600. Over the past five-year period, the MidCap 400 has delivered an average annualized return of nearly 7 percent, substantially ahead of the other two indexes.

Investors haven’t been flocking to mid-caps, despite those numbers. For example, they’ve withdrawn a net $2.4 billion over the past 12 months from funds that specialize in mid-cap growth stocks. Yet those funds have returned nearly 26 percent over that period, according to Morningstar.

Here are five things investors should know about mid-caps:

1. Mid-caps defined: There’s no firm rule about where to draw the line between small- mid-, and large-caps, based on the market value of those stocks. The S&P MidCap 400 takes a narrow approach. That index includes stocks with market caps ranging from $1 billion to $4.4 billion, which make up about 7 percent of the stock market. Another small-cap index, the Russell Midcap, includes 800 companies and covers nearly 29 percent of the market. The average market cap of its components is about $8 billion, nearly twice as much as the top end of the S&P MidCap 400. The market cap range in the Russell Midcap runs from $1.6 billion to more than $18 billion.

Those discrepancies can make it hard to figure out an appropriate percentage of mid-cap stocks for your portfolio. Most investors should aim for 15 to 20 percent of their stock portfolios in mid-caps, says Dan Culloton, a Morningstar fund analyst. Around 70 percent is a reasonable target for large-caps, with the rest in small-caps.

2. Best of both worlds: Mid-caps tend to possess the strengths and the weaknesses of large and small-caps, but to a lesser degree. One plus: Medium-sized companies have more room to expand, so there’s the potential for rapid earnings growth. One example of a mid-cap stock that has risen through the ranks is Netflix Inc. Its stock price has risen fivefold since the start of 2010 amid phenomenal growth for the company’s online video subscription service. But Netflix graduated from the mid-cap ranks in December when it was added to the S&P 500, and the stock now has a market cap of $14 billion.

Companies in the mid-cap range also include those that continue to grow rapidly after moving up from the small-cap ranks. One example: Lululemon Athletica Inc., a yoga apparel retailer with a market cap of nearly $8 billion. Its shares have nearly doubled this year.

3. The weak spots: It’s nearly impossible for medium-sized companies to grow rapidly without a bigger rival throwing its weight around in response to the competitive threat, says Chris Jones, a stock strategist with J.P. Morgan Asset Management.

“Mid-cap growth stocks suddenly get on the radar of big companies with huge resources that can use them very effectively,” he says.

Think of department store chains that couldn’t compete against Wal-Mart’s prices. Medium-sized companies may also lack the vast financial resources and diversified product lineups that larger companies use as a cushion when the economy trips up.

4. Track records: Medium-sized companies have long-term histories that investors can use to gauge stocks, making mid-caps less speculative investments than small-caps. Trading volume is also greater with mid-caps, which tends to make changes in their stock prices less erratic.

5. Be price-conscious: Because mid-cap stocks have performed well recently, there’s a chance that their strongest gains are behind them. It’s rare for stocks to maintain long runs in which they’re expensive relative to the earnings they generate. The price-earnings ratio of the S&P Midcap 400 was nearly 24 at the end of June. That measure shows how much investors are paying for a dollar in earnings over the past 12 months. The S&P 500 was comparatively inexpensive with a P/E of 16.

Still, Lazorishak and Grefenstette continue to see plenty of mid-cap investing opportunities. Grefenstette currently likes companies at the forefront of cloud computing — software and services such as data storage and email delivered and managed over Internet connections, rather than kept on local company desktops and servers. One of his fund’s Top 20 holdings, NetApp Inc., provides such services.

He also likes agricultural companies, such as another fund holding, Corn Products International. He figures global population growth will boost demand for food, lifting the stocks of agricultural companies.

One of Lazorishak’s favorite stocks if CommVault Systems Inc., recently his fund’s fourth-biggest holding. Its shares are up 38 percent this year, and Lazorishak expects continued growth for the company’s data management software.

Morningstar’s Culloton advises investors to be cautious, noting that funds specializing in mid-cap stocks have returned more than 20 percent on average over the past 12-month period.

“They’ve had a pretty decent run,” he says, “and it might be time to be a little careful.”

Jim Grefenstette is manager of the Federated Mid Cap Growth Strategies Fund. Courtey of Federated Investors