Three reasons to revisit a U.S. mid-cap equity allocation
Current prospects for U.S. mid-cap equities look strong, given solid fundamentals, rising earnings, and attractive valuations. Add declining interest rates into the mix, and the case for the asset class looks even stronger.
Mid-cap stocks occupy a unique position in the market as they’ve historically offered a blend of growth potential, reasonable valuation, ample liquidity, and favorable risk/reward characteristics, in our experience. Currently, the potential value of mid caps as a source of portfolio diversification has been amplified, given the historic concentration risk in large-cap equities created by today’s outsize market footprint of the technology-oriented Magnificent Seven stocks.
Here are three additional reasons why we believe now is an opportune time to revisit a mid-cap allocation:
1 Growth opportunities with lower volatility—Mid caps sit comfortably between large and small caps, offering higher growth potential than large caps with lower volatility compared with small caps.
2 Abundant choices—With over 2,000 companies in the mid-cap universe, there’s ample opportunity to discover attractive, less-followed stocks that may be undervalued or underappreciated by the market.
3 Diversification and risk management—Mid caps serve as proven diversifiers for portfolio allocation, providing favorable risk/reward characteristics that enhance the overall performance.
Mid caps’ low profile may be especially undeserved recently, as fundamental measures of mid-cap stocks paint a compelling picture, in our view. In addition to providing greater financial liquidity and access to capital compared with small caps, mid caps offer anticipated earnings growth on par with large caps, but trade at much cheaper valuations.1
Despite these potential advantages, mid caps often fly under the radar due to two key factors. First, some institutional mandates may restrict investment in mid caps, leading to less attention from institutional asset managers. Second, fewer Wall Street analysts tend to cover for mid caps compared with large caps, resulting in a lack of attention from investors.
Today’s mid-cap opportunities
As for the current market environment, we view the value style segment of the mid-cap universe as one of the most attractive areas of the U.S. equity market based on recent valuations versus historical averages. Furthermore, over the past three years, the valuation discount for mid caps relative to large caps has been near its widest level since the late 1990s.
Mid caps look attractive relative to their large-cap counterparts
Forward price-to-earnings ratio of the S&P MidCap 400 Index versus the S&P 500 Index, 1998–2024
Moreover, the valuation advantage for the mid-cap value style relative to the mid-cap core style was recently larger than its historical average. As of December 31, 2024, the forward price-to-earnings ratio for the S&P MidCap 400 Value Index was 13.55—a 14% discount relative to the S&P MidCap 400 Index’s 15.76 figure versus a 20-year average discount of 10%.2
Looking ahead, analysts expect mid caps to generate accelerating earnings growth entering 2025, which could serve as a catalyst to drive more investor attention to the asset class.
The current environment of declining interest rates could yield another tailwind. The U.S. Federal Reserve (Fed) in December 2024 approved its third rate cut in four months, with market expectations as of early 2025 indicating a likelihood of one or two additional quarter-point cut by year end.3 While that outlook represents a retreat from previous expectations of three to four cuts for 2025, rates remain on a clearly downward path—the type of an environment in which smaller stocks have historically performed well. In fact, small and mid caps have typically outperformed large caps during the first 3, 6, and 12 months following initial Fed rate cuts.
Following rate cuts, small and mid caps have typically outperformed large caps
Average performance of small-, mid-, and large-cap stocks in the first 3-, 6-, and 12-month periods following initial interest-rate cuts by the U.S. Federal Reserve, 1963–2024 (%)
The bottom line for us is that mid-cap stocks have offered a better risk/reward profile and attractive characteristics regardless of the economic environment. Despite being underappreciated and underowned by investors, mid caps present a compelling investment opportunity and a potential diversifier within a portfolio’s equity allocation, in our view.
1 Bloomberg, as of 1/17/24. 2 FactSet, as of 12/31/24. 3 CME FedWatch, as implied by 30-day federal funds futures prices, 1/9/25.
Important disclosures
The views presented are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Any economic or market performance is historical and is not indicative of future results.
Earnings per share (EPS) is a measure of how much profit a company has generated calculated by dividing the company's net income by its total number of outstanding shares. The forward price-to-earnings (P/E) ratio is a stock valuation measure comparing the current share. price of a stock with the underlying company’s estimated earnings per share over the next 12 months. The S&P MidCap 400 Index tracks the performance of 400 mid-cap companies in the United States. The S&P MidCap 400 Value Index tracks the performance of value companies in the S&P MidCap 400 Index. It is not possible to invest directly in an index. Market capitalization is the value of a corporation determined by the market price of its issued and outstanding common stock.
Investing involves risks, including the potential loss of principal. The stock prices of midsize and small companies can change more frequently and dramatically than those of large companies. Value stocks may decline in price. Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability. Large company stocks could fall out of favor, and illiquid securities may be difficult to sell at a price approximating their value. These products carry many individual risks, including some that are unique to each fund. Please see each fund’s prospectus to learn all of the risks associated with each investment. Diversification does not guarantee a profit or eliminate the risk of a loss.
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