A third of the way through February, mid-cap stocks have continued their January outperformance over large-cap and small-cap stocks that I discussed in last week’s All-Star article entitled Answering the Small-Cap Skeptics. Through February 8^th, the year-to-date performance ranking is as follows:

2013 Year-to-Date Performance

Although it is a well-established fact that small-cap stocks outperform all other market capitalizations over the very long term – and almost all of the biggest winning stocks of the past decade were small caps — investors should nevertheless invest a healthy allocation of their equity portfolio in mid-cap stocks too. 

Mid-cap stocks have many favorable characteristics, First, they often outperform both small-cap and large-cap stocks over intermediate time frames. For example, they have not just outperformed since the beginning of 2013, they have also performed the best over the past ten years:

10-Year Annualized Performance

(Jan. 2003- Jan. 2013)

Source: Morningstar

Going even further back, according to Roxbury Capital Management (page 4), mid-caps also outperformed over the 5, 10, and 15-year periods ending in December 2004 (page 4). Of course, raw returns are not the only thing that matter – downside volatility and return per unit of risk taken are also important. If you look at the 10-year table above, one can see that mid-cap stocks are more volatile (17.8% standard deviation per year vs. 14.8%) and have higher betas (1.14 vs. 1.00) than large-cap stocks – which is undesirable – but the higher return more than makes up for the higher volatility. The table lists four risk-adjusted performance metrics and mid caps rank highest on each one:

Sharpe Ratio: [(Annualized Return – Annualized Risk-Free Rate)/Total Annual Volatility]. Risk-free rate is the 10-Year U.S. Treasury Note, which averaged about 2.25 percent over the past decade.

Sortino Ratio: [(Annualized Return – Annualized Risk-Free Rate)/Downside-only Annual Volatility].

Alpha: Annualized return – Beta * Benchmark index annualized return

Treynor Ratio: [(Annualized Return – Annualized Risk-Free Rate)/Beta].

Mid Caps Offer Both Growth and Safety

I think the reason that mid-cap stocks perform so well on all of these metrics is that they are in the “sweet spot” of investment performance generally, as well as the growth phase of their individual business lives. The great Greek philosopher Aristotle wrote that the key to happiness was the “happy medium” between the two extremes. Similar concepts are the “golden mean” and the saying “moderation in all things.”  As a simple mathematical example of this phenomenon, consider a numerical range between 0 and 10. The exact middle of this range is 5. Multiplying 5 by itself yields a higher value (25) than 4 by 6 (24), 3 by 7 (21), 2 by 8 (16), 1 by 9 (9), or 0 by 10 (0). The closer you get to the extremes, the less value you get.

In the case of the stock market, the two extremes are stability and growth potential. Large caps have the most stability but the least growth potential and small caps have the most  growth potential but the least stability. Mid caps have both stability and growth potential – the happy medium. John Roth, portfolio manager of Fidelity Mid-Cap Stock Fund, explains it this way:

There’s less of an opportunity in large caps to hit home runs, but there’s also correspondingly less opportunity to blow yourself up, because these businesses are a lot bigger and a lot more stable. While there has been a lot more opportunity to hit those home runs in the small-cap space, there also are a lot of ways to experience blowups.

In mid-caps, however, while the opportunity set to log those long-ball stock picks has been somewhat lower than in small caps, the foul-out quotient is significantly lower as well, which strikes a nice overall balance.

As I wrote in Buy Small-Cap Stocks Before They Grow Up, small-cap investing is very rewarding but also very difficult because a majority of small-cap stocks actually lose money – all of the outperformance is generated by less than 44 percent of small caps. While there are a manageable 397 large-cap stocks with market caps above $10 billion on U.S. stock exchanges, along with 628 mid-cap stocks between $3 billion and $10 billion, there are thousands of small-cap stocks under a $3 billion market cap. It takes a lot of time and effort to sift through thousands of stocks to find the minority that are the big winners. I enjoy the challenge and have done well investing in small caps, but for those “do-it-yourselfers” who can’t make the huge time commitment necessary to separate the wheat from the chaff, mid caps offer a higher probability of success.

Mid Caps are Proven Winners

The reason is that mid caps are – by their very nature – proven winners. They are companies that started out as small caps and have already succeeded at growing their business sufficiently to achieve “escape velocity” out of the small-cap world and earn a spot in the mid-cap world. Roxbury Capital Management explains it this way:

In many cases, mid-caps are former small-cap companies that have managed to thrive, proving the value and sustainability of their business plans.

Because mid-cap companies have been around longer than most small-caps, they normally have stronger, more established products and services, along with seasoned and experienced management teams, larger market shares, stronger name recognition, global exposure, and existing revenues. In turn, mid-caps generally offer less business execution risk for investors than small-caps.

So, mid caps are safer bets than small caps, but they also retain most of the fantastic growth potential of small caps with much less risk. Although larger than small caps, they are still much smaller than large caps. As mid-cap fund managers at TIAA-CREF put it:

We believe mid-cap stocks are in the “sweet spot” of the investment universe, combining attractive attributes of both large and small companies. Typically, mid-cap companies are large enough to have seasoned management teams, sophisticated information technology, broad distribution channels, strong overall market presence and ready access to capital markets — advantages that very small or start-up companies may lack. At the same time, mid-cap companies can grow more quickly than their large-cap counterparts, benefiting from potentially less bureaucracy, fewer layers of management and generally a more entrepreneurial spirit that can help speed decision-making.

In addition, mid-cap firms are sometimes acquired by larger companies looking to grow faster, capture market share, offer new products, enter new markets, gain economies of scale or obtain intellectual property quickly. They also are more likely to benefit from management buyouts in which private equity firms purchase mid-cap companies; when successful, leveraged buyouts can potentially boost investment returns.

Here at Roadrunner Stocks, we invest in both small caps and mid caps because they both offer excellent growth potential. Large caps are the only sector we avoid. Right now, of the 10 recommended stocks in Roadrunner’s Value and Momentum portfolios, seven are small cap and three are mid cap. The three best-performing Roadrunner stocks so far are all already up double digits since they were recommended less than three weeks ago.

What market cap are the top two performers? Mid-cap stocks ($5.5 billion and $3.2 billion), but one of them was small-cap ($2.6 billion) when I recommended it!