When Middle of the Road is the Right SMA Path
August 30, 2004
When he talks about mid-caps, money manager Sandy Lincoln likes to recall the time when his then eight-year-old and six-year-old daughters asked if they could baby-sit. "I said, well, at eight years old, you can't baby-sit," he recalls. However, the older daughter had heard him make practice presentations at home and replied, "But between me and my younger sister, we have 14 years of experience."
Lincoln uses that story to illustrate the point that sometimes the sum of the parts is just parts: An eight-year-old and a six-year-old don't add up to a 14-year-old. The chief investment officer of Wayne Hummer Asset Management in Chicago, a firm with $1.4 billion under management--40% percent of it in mid-cap separately managed accounts and mutual funds--says that's just the kind of thinking that investors use when they overlook the virtues of mid-cap stocks.
Until recently, mid-cap stocks, which Wayne Hummer defines as those in the $1 billion to $12 billion range, were under-appreciated as a class. Investors often assumed that if they owned large-cap and small-cap stocks, they didn't need the additional exposure, according to Lincoln. Mid-caps also didn't spark investors' imagination. Lacking the solidity and impressiveness of large-caps or the get-rich-quick allure of small-caps, the category was often overlooked.
But that's unfair, said Lincoln, who has found that mid-caps actually offer a better risk-adjusted return than either large- or small-caps.
Wayne Hummer analysts point out that over the past five and 10 years, mid-caps have outperformed both great and small, as measured by the Russell 1000 Index for large-caps, the Russell Mid-cap Index and the Russell 2000 Index for small-caps. At five years, mid-caps produced a 7.23% return, compared to 7.15% for small-caps and negative 0.14% for large-caps. At 10 years, the mid-cap index outperformed again, producing a 12.17% return compared to large-cap's 10.99% and small-cap's 9.48%.
The reason for that performance may be due to some special qualities that the stocks share as a group. As a class, mid-caps actually have some special characteristics, according to Lincoln. With a mid-cap name, there's less risk that the company will simply fall apart, like a small-cap stock. At the same time, unlike large-caps, there's still a big opportunity for double-digit growth in a mid-cap company. Yet the category is under-represented in the fund universe, Lincoln said. Although mid-caps represent 21.7% of all stocks by market-cap, they collected only 12% of mutual fund assets until recently, according to Morningstar figures compiled by Wayne Hummer analysts.
Now, however, that may be changing. Lincoln noted that in 2004 through the end of June, mid-cap-focused mutual funds were the third-most popular fund variety, right behind large-cap growth and value.
Of course, mid-caps have their own special risks as well as their own special virtues, according to Lincoln. Sometimes a company has grown so quickly that it has outgrown its management team. Or, he says, it may still be overly reliant on a particular distribution channel or a particular product. There's also somewhat greater event risk with a mid-cap company than with a large-cap. If something goes wrong with a GE imaging machine, that's a small hit to the numerator of a $300 billion denominator, Lincoln says. Not so with mid-caps, which tend to operate in niches where there are two or three competitors. For instance, Avery Denison, a sticker and adhesive stationery manufacturer that Wayne Hummer owns, recently took a sizable hit to its market cap because two competitors in its niche were charged with price collusion.
Finally, the position of mid-caps can make them more vulnerable to squeezes from both large and small companies. "I think you do have to be very conscious when you're dwelling in the mid-cap arena that you're not losing sight of developments that might be life-threatening at either extreme," Lincoln said. A small company might come up with a very innovative new product, for instance. On the other hand, a large company might enter the space and open a new distribution channel.
Choosing the 40 to 50 names that make up their mid-cap portfolios requires roughly four of Wayne Hummer's investment staff of 10. Great care is taken in making those choices, which can take between six and nine months. When they finally add a name, Lincoln said, there's no real difference between their mutual fund and their managed account portfolios. Where their separately managed account portfolios differ is not so much in names as in allocations. While the mutual fund includes stocks that have appreciated since their purchase, a separately managed account always begins with fresh positions.
Stocks that make the cut tend to have a high return on equity, Lincoln said. He said his team focuses on buying growth stocks at a fair price rather than "fallen angels." They also tend to like companies that produce things either consumers or businesses need, such as McCormick, the spice company.
Many of the stocks they end up with are for midwestern industrial companies, Lincoln said.
One factor that favors such companies is that they often have the opportunity to meet the managers and really get to know the companies. "We can see them, and because they are mid-size, they will frequently come to see us," he added. Managers at Zebra Technologies, the Vernon Hills, Ill., company that makes barcode printers, for instance, often visit Wayne Hummer once or twice a year, or someone from his team will go to hear them speak. Other local heroes include Pactiv, the manufacturer of Hefty bags, which is based in Lake Forest, Ill., and Gentex, a Holland, Mich., company that supplies dimmer-mirrors to the automotive industry.
Now the group's cautious strategy seems to be paying off. With mid-cap now the third-most-popular equity mutual fund category for the first part of the year, Lincoln is optimistic that things will keep humming at Wayne Hummer for a while. "We think the category is starting to get some attention, and we're hopeful that we've been there long enough with our story that we'll get some of that action," he said