The correlation coefficient has limited ability in predicting returns in the stock market for individual stocks. Still, the statistical measurement may have value in predicting the extent to which two stocks move in relation to each other because the correlation coefficient is a measure of the relationship between how two stocks move in tandem with each other, as well as the strength of that relationship.

Modern Portfolio Theory

Although the correlation coefficient may not be able to predict future stock returns, the tool is helpful for the understanding (and mitigation) of risk because it is a central component of modern portfolio theory (MPT), which seeks to determine an efficient frontier. The efficient frontier, in turn, provides a curved relationship between a possible return for a mix of assets in a portfolio versus a given amount of risk for that mix of assets.

The Correlation Coefficient

The correlation coefficient is measured on a scale from -1 to 1. A correlation coefficient of 1 indicates a perfect positive correlation between the prices of two stocks, meaning the stocks always move in the same direction by the same amount. A coefficient of -1 indicates a perfect negative correlation, meaning that the stocks have historically always moved in the opposite direction. If two stocks have a correlation coefficient of 0, it means there is no correlation and, therefore, no relationship between the stocks. It is unusual to have either a perfect positive or negative correlation.

Investors can use the correlation coefficient to select assets with negative correlations for inclusion in their portfolios. The calculation of the correlation coefficient takes the covariance of the two variables in question and each variable’s standard deviation.

While standard deviation is a measure of the dispersion of data from its average, covariance is a measure of how two variables change together. By dividing covariance by the product of the two standard deviations, one can calculate the correlation coefficient and determine to what extent assets in a portfolio are likely to move in tandem.

Predictive Power

The correlation coefficient is a linear regression performed on each stock’s returns against the other. If mapped graphically, a positive correlation would show an upward-sloping line. A negative correlation would show a downward-sloping line. While the correlation coefficient is a measure of the historical relationship between two stocks, it may provide a guide to the future relationship between the assets as well.

However, the correlation between the two investments is dynamic and subject to change. The correlation may shift, especially during times of higher volatility, just when risk increases for portfolios. As such, MPT may have limitations in its ability to protect against risk during periods of high volatility due to the assumption that correlations remain constant. The limitations of MPT also limit the predictive power of the correlation coefficient.

The Bottom Line

Correlation is used in modern portfolio theory to include diversified assets that can help reduce the overall risk of a portfolio. One of the main drawbacks of MPT, however, is that it assumes the correlation between assets is static over time. In reality, correlations often shift, especially during periods of higher volatility. In short, while correlation has some predictive value, the measure has limitations in its use.

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.

Despite the overshadow of trade tariffs, industrial stocks remain underpinned by a lower corporate tax rate (35% down to 21%), a push for increased infrastructure spending and a strengthening U.S. housing market. Economic data also shows increased industrial activity. Industrial production, which measures the value of output from manufacturers, mines and utilities, is up 5.1% year over year as of September 2018. The sector should additionally benefit from early investor rotation into value names, robust profit forecasts and increased buyback activity.

Senior analyst at Wolfe Research Nigel Coe told Barron’s that he believes industrial stocks can maintain strong growth momentum while the Federal Reserve’s policy remains loose and supportive of growth. However, he cautioned that companies in the sector need to grow into their earnings multiples – forward earnings currently sit at 16.7 times as of October 2018. Price action also suggests that industrial stocks are at key support levels. Three leading exchange-traded funds (ETFs) in the sector have all bounced at critical technical areas on their respective charts. Let’s further analyze each fund.

Launched in 2006, the iShares U.S. Aerospace & Defense ETF seeks to track the performance of the Dow Jones U.S. Select / Aerospace & Defense Index. The fund invests in companies that manufacture, assemble and distribute airplane and defense equipment. ITA charges investors an annual management fee of 0.43% and has returned 9.3% year to date (YTD) as of October 2018. The recent pullback found support on the uptrend line the connects the early May and late June swing lows. This $200 support level on the chart also finds support from the 200-day simple moving average (SMA), making it a high-probability buying area. A stop-loss order could be placed just below the candlestick that reversed on the trendline/moving average.

The Invesco DWA Industrials Momentum ETF, also created in 2006, aims to provide similar returns to the DWA Industrials Technical Leaders Index. The ETF’s portfolio holds U.S. industrial firms that are showing strong relative strength and price momentum. As of October 2018, the fund has a -4.69% YTD return and charges a 0.6% management fee. PRN’s chart appears to be forming a double bottom – the most recent swing low found support near the early May swing low at the $57 level. Short-term momentum looks to be moving back to the upside, with the relative strength index (RSI) crossing back above 30. Stops should be placed slightly below double bottom pattern to protect trading capital.

Formed in 2013, the Fidelity MSCI Industrials ETF attempts to replicate the performance of the MSCI USA IMI Industrials Index. It holds companies that cover the broad U.S. industrials sector. The fund has a low expense ratio of just 0.08%, well below the 0.5% category average. Performance wise, FIDU has returned -1.33% YTD. Although FIDU’s share price is trading below the 200-day SMA, it found strong support from the uptrend line that commenced in early May. The recent bounce at the $37.5 support level has moved the RSI out of oversold territory and occurred on above-average volume. Traders who take a long position should protect it with a stop below the most recent swing low.