Golfers refer to the “sweet spot” as the position on the face of the club head that when hit produces the maximum result. A very similar result occurs when investing in mid-cap stocks, those companies with market capitalizations ranging from $2 billion to $10 billion. Most often, they are established businesses sandwiched between slower growth large-cap multinationals and faster-growing small-cap businesses.

In recent years, mid-cap stocks have outperformed both their large-cap and small-cap peers with very little added risk. It’s as if they have hit the sweet spot of performance. In this article, we examine the key attributes of mid-cap stocks including how to analyze them and why you should consider these often-misunderstood stocks for your portfolio.

Why Include Mid-Caps in Your Portfolio

Having already established that the historical performance of mid-cap stocks is equal to or in many cases better than both large-cap and small-cap stocks, it’s important to point out that performance isn’t the only reason to include mid-caps in your portfolio. Several others make them very tempting indeed. For example, most mid-caps are simply small caps that have grown bigger. Additional growth makes them the stepping stones to becoming large-cap businesses. Part of growing is obtaining additional financing to fuel expansion. Mid-caps generally have an easier time of it than small caps do.

While mid-caps have an advantage over small caps when it comes to raising funds, their advantage over large caps amounts to earnings growth. Smaller in size, mid-caps often have yet to reach the mature stage where earnings slow and dividends become a bigger part of a stock’s total return. Possibly the most overlooked reason for investing in mid-caps is the fact that they receive less analyst coverage than large caps because they are less known yet and many analysts have not spotted them yet or they have not piqued the interest of the mainstream readers of analyst reports. At the same time, they have already graduated from the high-risk zone of small-cap stocks, and their business model is much more proven.

Some of the best-performing stocks historically have been unloved companies that suddenly became loved, producing the institutional buyers necessary to move their price higher. Some call this the “money flow.” Call it what you will, institutional support is vital to a rising stock price. These big players can both create and destroy value for shareholders. In the end, investing in mid-caps makes sense because they provide investors with the best of both worlds: small-cap growth combined with large-cap stability.

Profitability

One of the beautiful things about mid-cap stocks is that you’re investing in businesses that are generally profitable, have been for some time and possess seasoned management teams. This doesn’t mean they’ve stopped growing; on the contrary, the average mid cap’s earnings tend to grow at a faster rate than the average small-cap while doing so with less volatility and risk. In addition to earnings growth, it’s important to find stocks whose earnings are sustainable for many years to come. That’s what turns a mid-cap into a large-cap.

Telltale signs indicating whether a company’s earnings are heading in the right direction include higher gross margins and operating margins combined with lower inventories and accounts receivable. If it routinely turns its inventory and receivables faster, this usually leads to higher cash flow and increased profits. All of these attributes help reduce risk. Mid-cap stocks tend to possess these attributes more frequently than other stocks.

Financial Health

Whatever size stock you’re interested in, it’s important to invest in companies with strong balance sheets. Famed investor Benjamin Graham used three criteria to assess the financial health of a company:

• Total debt that is less than tangible book value. Tangible book value is defined as total assets less goodwill, other intangible assets, and all liabilities.
• A current ratio greater than two. Current ratio is defined as current assets divided by current liabilities. It is an indication of a company’s ability to meet its short-term obligations.
• Total debt less than two times net current asset value. Companies meeting this criterion are able to pay off their debts with cash and other current assets making them far more stable.

Given the unpredictability of business, a strong balance sheet can help companies survive the lean years. Because mid-caps tend to have stronger balance sheets than small caps, this reduces risk while providing superior returns to large caps. When investing in mid-caps, you are in a sense combining the financial strength of a large-cap with the growth potential of a small-cap with the end result often being above-average returns.

Growth

Revenue and earnings growth are the two most important factors in long-term returns. In recent years, mid-cap stocks have outperformed both large-cap and small-cap stocks because of their superior growth on both the top and bottom lines. Industry experts suggest mid-caps are able to produce better returns because they are quicker to act than large caps and more financially stable than small caps, providing a one-two punch in the quest for growth.

Investors interested in mid-cap stocks should consider the quality of revenue growth when investing. If gross and operating margins are increasing at the same time as revenues, it’s a sign the company is developing greater economies of scale resulting in higher profits for shareholders. Another sign of healthy revenue growth is lower total debt and higher free cash flow. The list goes on, and while many of the criteria investors use to assess stocks of any size definitely apply here, it’s vitally important with mid-caps that you see progress on the earnings front because that’s what’s going to turn it into a large-cap. Revenue growth is important but earnings growth is vital.

Reasonable Price

Nobody wants to overpay when shopping, and buying stocks is no different. Warren Buffett believes that “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Many refer to people interested in growth at a reasonable price as GARP investors. Some of the things GARP investors focus on when evaluating mid-cap stocks include growth measures like sales and earnings growth rates along with value measures like price/earnings and price/cash flow.

Whatever measures you choose, the most important criteria should be the quality of the company. As the Oracle of Omaha says, it doesn’t make sense to get a great deal on a dud company. Deep-value investors might disagree, but true GARP followers are simply looking to avoid overpaying, not obtaining the deal of the century. 

Stocks or Funds

Investing in mid-caps is an excellent way to simultaneously diversify and enhance the performance of your investment portfolio. Some investors will find there’s too much work involved in evaluating individual stocks, and if that’s you, an excellent alternative is to invest in exchange-traded funds or mutual funds, letting the professionals handle the evaluation process. Whatever your preference is, mid-caps are definitely worth considering.

Most investors evaluate mutual funds using the principles of fundamental rather than technical analysis. Mutual funds tend to be long-term, buy-and-hold investments, and technical analysis is better suited to shorter-term trading.

That said, investors should not overlook the value of some common technical indicators to provide trading insights for almost any kind of investment or financial instrument, including mutual funds. Below are five common technical indicators that can be applied to mutual funds.

1. Trendlines

Most technical analysis starts with trendlines, which are lines that connect multiple price points and extend into the future to identify price trends and areas of support/resistance. For mutual funds, look at a long-term price chart in order to determine its trend.

A trendline can be plotted by drawing a line that connects multiple lows of a mutual fund over time. The fund may have tested this trendline on numerous occasions over the years. If the fund price breaks conclusively through a well-established, long-term trendline, it is a bearish signal. An investor in such a fund should consider selling their fund holdings if this occurs.

Conversely, a breakout above a well-defined trendline may be a bullish signal, indicating the investor should stay in the fund. 

2. Moving Averages

Moving averages are averages of time-series data, such as prices. Investors can use these to identify price trends of a mutual fund. A rising moving average suggests that the fund is in an uptrend, while a declining moving average would indicate that it is in a downtrend.

A second major application arises from the crossover of two moving averages, for example, a short-term, 20-day moving average and a long-term, 200-day moving average.

If the 20-day moving average breaks above the 200-day moving average, this would be considered a bullish signal for the mutual fund. Conversely, if the 20-day moving average breaks below the 200-day moving average, this would be a bearish signal.

The 200-day moving average is considered a key technical indicator, with breaks above or below that regarded as important trading signals. It is especially suited for mutual fund technical analysis because of its longer-term nature.

3. Relative Strength Index (RSI)

The Relative Strength Index (RSI) is a momentum indicator that compares the magnitude of recent gains to recent losses in order to evaluate whether the mutual fund is overbought or oversold.

An RSI above 70 would suggest that the mutual fund is overbought and its value is overpriced and poised to retreat. An RSI below 30 indicates an oversold state that may trigger a bounce, which may bolster a value investor’s buy decision.

4. Support and Resistance

A support level is formed when a mutual fund trades down to a certain level and then bounces back up. Over time, this level becomes an area of strong support for the mutual fund. Conversely, a resistance area is formed when the fund is unable to break above a certain price level.

The further apart these tests of support and resistance, and the more frequent that the fund trades down or up to the support or resistance level, the more formidable they become. A break of long-term support is very bearish and may signal a substantial downside for the mutual fund. A move above long-term resistance is very bullish and signals significant upside.

5. Chart Formations

There are a number of different chart types used in technical analysis, with the most common being line charts and bar charts.

Advanced users may prefer candlestick charts to point-and-figure charts. Chart formations for a mutual fund can be interpreted like stocks. The head-and-shoulders pattern, for instance, is interpreted as being quite bearish for the fund, while the reverse head-and-shoulders pattern is viewed as a bullish signal.

A chart pattern that is easy to identify and that has a high degree of reliability is the double or triple top or bottom. A double top or triple top is typically formed after a long period and signals an imminent trend reversal; if a mutual fund that has been trending higher is unable to break through this formation, it may be headed lower. Conversely, a fund that has formed a double or triple bottom may be poised to move higher.

The Bottom Line

While mutual funds do not readily lend themselves to technical analysis, investors can apply some common technical indicators to predict mutual fund movements. Technical indicators like trendlines, moving averages, RSIs, and chart formations are widely used in mutual fund analysis as they provide reliable signals that are easy to interpret.