Mid Cap Stocks: Maximizing Performance on a Risk-adjusted Basis
By Patrick Dunkerley, CFA
Senior Vice President UMB Asset Management
Analysis and opinions from UMB Volume 3, Issue 1
Opportunities often arise in places that have been ignored by most investors, strategists and advisors. One such opportunity is in mid cap U.S. equities. This paper outlines a disciplined process for managing a mid cap stock portfolio for notable risk-adjusted returns. We offer evidence that investors should participate in this asset class — and maximize their returns within the mid cap universe by applying proven skills of active management. We deﬁne mid caps as stocks with $1.5 billion to $17 billion
By Derek M. Smashey, CFA
Assistant Vice President UMB Asset Management
in market capitalization, a range that is characterized by established, mature companies, along with some ﬁrms that are still growing rapidly.
Executive Summary: This paper outlines proven management disciplines for achieving notable risk-adjusted returns in a portfolio of mid cap equities.
Mid cap opportunity fuels returns Mid cap equities represent a neglected asset class. Financial pundits and the press often ﬁxate on the large cap giants of the market, or on small cap “stars,” but few in between. Yet data from the past 20 years show that mid cap stocks have outperformed the large cap and small cap stocks, in both absolute and risk-adjusted returns.1
MID CAPS OUTPERFORM LARGE & SMALL STOCKS: 20-Year Growth in Value of $1 Invested in 1987
Russell Top 200
Russell MidCap Russell 2000
$1 grew to $11.55
’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06
Source: Calculated by “UMB Financial Corporation” using information and data presented in Ibbotson Investment Analysis Software, ©2007 Ibbotson Associates, Inc. All rights reserved. Used with permission.
Mid Cap Investing
In a given time period, one equity category or another may outperform, but the record shows a 13.6 percent average total return for mid caps over two decades, higher than large caps (11.5 percent) or small caps (10.3 percent). Mid caps also delivered notable returns over 10, 5 or 3 years, as well as in 2005. Risk-reward tradeoffs provide further evidence of the mid cap advantage as a performance leader over the past 20 years. Disciplined process can beat benchmarks Participating in the mid cap asset class is just a ﬁrst step. Outperforming the benchmarks requires skill in three important investment disciplines:
Economic Factors Secular Themes Flexible Screens
Fundamentals Valuation Intangibles
Prior to reviewing individual stocks, we collect top-down information from many sources. We do a weekly review of more than 100 macroeconomic variables — watching trends, spotting changes, seeking clues to industries that may win or lose. The goal is to develop a few value-driving themes, then screen for mid cap stocks that can beneﬁt. Examples of themes we have pursued: the implications of a “soft landing” in the economy, demographic trends for baby boomers, the buying habits of wealthy consumers, and supplydemand trends in major commodities such as oil and grains.
Top-down research — looking at secular trends, ﬁscal and monetary policy, and broad changes to target potential areas to invest (or avoid).
Bottom-up analysis — selecting companies based on study of their ﬁnancial fundamentals, catalysts for change and stock valuations.
Portfolio construction — constantly evaluating how each holding ﬁts into an overall portfolio to maximize the overall risk-adjusted returns.
✓ ✓ ✓ ✓ Economic trends Industry changes Value drivers Company impacts
There is no shortcut to outperformance. A consistent, thorough process can segregate the universe to stocks offering the greatest promise — and weed out the likely underperformers. In these pages we offer some examples, from our experience, of how this process plays out in building and managing a mid cap portfolio in the real world. Top-down research reveals value drivers Market values of individual equities are inﬂuenced greatly by macroeconomic changes and trends in industries and markets.2 As a result, top-down research reveals areas of the mid cap asset class with more opportunity — and less danger — than others. In tracking retail sales, for instance, we noticed that spending by wealthy consumers showed momentum in spite of rising energy costs and interest rates. This led us to an investment theme that stocks of high-end retailers, including established and growing chains in the mid cap sector, should offer opportunities to outperform.
Mid Cap Investing
The secular increase in energy prices, another top-down theme, is a “macro” trend that drives sales and proﬁts in some industries — and hurts others. We have followed the interplay of economic growth and demand for oil, as well as supply adjustments in the world market. This theme led us to mid cap oil exploration and production stocks, at opportune times. The energy price theme also helped pinpoint some market sectors to avoid. Finally, shortages of grain due to population and wealth expansion, and high energy prices drive our agriculture theme. As political winds shift toward biofuels, certain areas of the stock market can beneﬁt. Macro trends are constantly changing, and a shift can create or destroy value, sometimes quickly. It’s critical to stay engaged, testing themes, discarding ideas and searching for new ones. With top-down themes in hand, we screen the sectors of the market that stand to beneﬁt — and start with a short list of mid cap stocks to evaluate.
Our initial study of fundamentals may provide some level of conviction for a stock, but we typically take time to watch the performance. We may buy a smaller starter position, then gather more information, watch quarterly earnings and other news, and see if additional data conﬁrms a decision to invest more.
✓ ✓ ✓ ✓ Cash ﬂows Balance sheet Operating margins Sustainability
Valuation — Buying at a discount to intrinsic value is every investor’s goal. We develop a discounted earnings model on a company we are considering, to incorporate the dynamics of the business going forward in our valuation.5 Our discounted earnings model, while requiring more
Bottom-up analysis fuels stock selection Building on a macro theme, bottom-up analysis seeks out the companies and stocks that can beneﬁt the most. Without detailing speciﬁc techniques, we offer these bottom-up principles:
research and analysis, estimates the fair value of future earnings streams. The ﬁgures include impact of catalysts for change in performance, whether from top-down trends or bottom-up factors like a new product launch or added market channel.
Fundamentals — Experience shows that equity returns are enhanced for companies with improving cash ﬂows.
✓ ✓ ✓ ✓ Projected earnings Change catalysts Risks & variability Discounted to present value
In addition, a healthy balance sheet, a history of sustainable operating proﬁts and strong cash ﬂows helps to reduce risk. Studying ﬁnancial statements is only partly a historical exercise. Changes in speciﬁc results (inventories, accounts receivable, gross margin and the like) often give signals that are predictive of future directions in earnings.4 Fundamental analysis isn’t all quantitative; it also involves judgment calls. How vulnerable are revenues to cyclical factors? How much debt is reasonable, given the volatility of cash ﬂows?
Mid Cap Investing
The discounted earnings model has received validation in empirical studies. Over time, this estimate of a company’s
Other factors such as technical analysis may also provide insights, but market data alone should not drive a decision to invest. The goal in bottom-up analysis is to own mid cap stocks backed by real businesses that generate positive cash ﬂows and have good management. Conversely, we seek to avoid companies that appear too risky or ﬂash warning signs of trouble. Risk-adjusted return serves investors’ goals In equity investing, it may be natural to focus on the “return” side of results, but we believe investors are best served by considering the risks, as well. That philosophy of risk-adjusted return should permeate the process of analyzing, selecting and managing a portfolio of mid cap equities. As stated at the outset of this paper, a risk-adjusted perspective is what led us to mid caps as an asset class. This “in-between” size category includes many mature companies, as well as rapid-growers, and mid cap stocks tend to trade in liquid markets, with adequate investor interest. Size and liquidity reduce the mid caps’ volatility, or risk, compared to small cap equities. To see how an investor or advisor might use the risk-return
value is inﬂuenced either by changes in expected future earnings, or economic shifts that affect the risk levels (or discount rates) applied in the model.7 While many value investors rely on low valuation ratios as a statistical measure of cheapness, we look at those ratios mainly as a way to avoid the excessive risk that comes with expensive stocks. We don’t invest based only on ratios that present a static, historically derived snapshot.
Intangibles — Some of the greatest risks are in the realm of intangibles, so we scrutinize each company’s management and board. Industry experts and a ﬁrm’s competitors can provide insight on management’s reputation. A strong board has diverse members, with broad business experience and in-depth industry knowledge. Aggressive accounting policies can be a warning sign for a company, leading to increased regulatory scrutiny and headline risk. We try to avoid problems with earnings quality by checking policies on revenue recognition and comparing net income with cash ﬂows over time.
✓ ✓ ✓ ✓ Management Accounting Litigation Other factors
tradeoff in practice, consider the following table comparing the Sharpe Ratio for three size classes of equities. Most investors would look only at total return; in this case, mid caps have the highest total return for the period. But investors also should look at risk; here, the mid caps’ standard deviation shows less volatility than small caps, but more than large caps.
Litigation represents another substantial risk. As an intangible, potential legal setbacks do not usually impact the income statement or balance sheet until it is too late. But litigation can be very costly, so these potential liabilities bear scrutiny.
Mid Cap Investing
Mid Caps Outperform In Total Return And Risk-Adjusted Return, 1987-2006
Asset Class Total Return Standard Deviation Reward-to-Risk Ratio
Seeking alpha — Buying an index fund or exchange traded fund (ETF) may deliver average returns for an asset class, but selecting a speciﬁc mix of holdings to diverge from a benchmark may improve portfolio returns. A recent study indicates the most active fund managers have historically outperformed less active fund managers and indexes.8 Pursuit of alpha can mean seeking opportunities or inefﬁciencies in valuation of a particular stock that other investors have overlooked. Essentially, it involves working to eliminate less promising stocks and to invest in more promising ones.
Large cap (Russell Top 200) Mid cap (Russell Midcap) Small cap (Russell 2000)
11.37% 13.43% 10.91%
14.95% 15.91% 19.12%
0.4482 0.5505 0.3264
Total return: geometric mean of annualized monthly results. Standard deviation: a statistical measure of price volatility. Reward-to-Risk Ratio, or Sharpe Ratio: total return, minus risk-free return (T-bill rate), divided by standard deviation. Source: UMB analysis of Russell Equity Index results
Avoiding danger — A real beneﬁt of in-depth analysis, both in tracking macroeconomic trends and in looking at fundamentals of companies, is to avoid investing in (or continuing to hold) stocks whose prospects turn negative. A portfolio built through consistent disciplines for selecting high-quality, sustainable companies will minimize dangers on the downside.
Combining these measures, the Sharpe Ratio reveals in a single ﬁgure how well investors are compensated in relation to the risk they accept. This adds a quantitative dimension, and discipline, to the typical investor’s intuitive view of risk. We believe ﬁnancial advisors should encourage investors to do this exercise more often — evaluating risk right along with the returns for asset classes, funds and speciﬁc investments. In selecting industries and individual stocks for our portfolio within the mid cap sector, we focus on maximizing performance on a risk-adjusted basis. That means paying attention to risk avoidance, as well as the prospect of returns, for each stock. At every stage of the process, protecting our investors’ wealth against losses is a primary goal, as important as the prospect of a capital gain. Disciplines build a strong mid cap portfolio Active management adds value in the mid cap sector by bringing a disciplined, repeatable process to the business of constructing a portfolio.
✓ ✓ ✓ ✓ ✓ Seeking alpha Avoiding danger Diversifying risk Selling on time Share liquidity
Diversifying risk — Diversiﬁcation is a somewhat different skill from avoiding warning signs of danger in speciﬁc stocks. Balancing the prospects and risks from one macro theme, or one group of stocks, with other holdings is a key management discipline. Effective diversiﬁcation of a portfolio requires specialized
We believe these disciplines will build a strong mid cap portfolio to deliver favorable risk-adjusted returns over the long haul:
training and experience. We focus continually on monitoring and adjusting the mix of industries, investment themes and risk factors.
Mid Cap Investing
Selling on time — Exercising the objectivity to sell a stock when the reasons for holding no longer exist, or when better opportunities arise, preserves and builds the value of the portfolio. Consistent, active sell disciplines are a key value that professional asset managers add in managing a portfolio, compared with the reluctance of individual investors to recognize mistakes and act decisively to minimize losses. Triggers to sell a stock, for example, might include negative company news, a change in top-down economic trends or investment themes, or valuation that has grown too rich.
Conclusion In summary, investors and advisors should consider mid cap equities as a core holding — and base their investments on a disciplined, repeatable process to enhance the rewards of a portfolio. We believe active management, using rigorous analysis and portfolio disciplines, can deliver notable returns in mid cap U.S. equities — compared with the asset class as a whole, as well as other categories of securities, over the long run.
Patrick P. Dunkerley, CFA Senior Vice President, UMB Asset Management Patrick Dunkerley is the lead portfolio manager of the Mid Cap strategy. Mr. Dunkerley is a CFA
Derek M. Smashey, CFA Assistant Vice President, UMB Asset Management Derek Smashey is the assistant portfolio manager of the Mid Cap strategy. Mr. Smashey is a CFA® charterholder and has more than 3 years investment experience. He joined UMB and the Advisor in 2006, following previous employment at Nations Media Partners, Inc. (2003-2006), where he served as an associate director, and Sprint Corporation (2000-2003) where he served as Internal Consultant. Mr. Smashey earned his undergraduate degree from the Northwest Missouri State University and his graduate degree from the University of Kansas. Mr. Smashey is a member of the Kansas City CFA Society and the CFA Institute.
charterholder and has
more than 13 years investment experience. He joined UMB and the Advisor in 2006, following previous employment at Victory Capital Management from 2001-2006, where he served as an assistant portfolio manager, and subsequently as chief investment ofﬁcer of mid cap core equity and as the lead portfolio manager of a mid cap mutual fund and separate accounts. Mr. Dunkerley earned his undergraduate degree from the University of Missouri and his graduate degree from Golden Gate University. Mr. Dunkerley is a member of the Kansas City CFA Society and the CFA Institute.
Mid Cap Investing
Glossary Alpha: A coefﬁcient that measures risk-adjusted performance, factoring in the risk due to the speciﬁc security, rather than the overall market. A high value for alpha implies that the stock or mutual fund has performed better than would have been expected given its beta (volatility). Asset class: A speciﬁc category of assets or investments, such as stocks, bonds, cash, international securities and real estate. Assets within the same class generally exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. Cash-ﬂow positive: Description of a company that generates more cash from operations than it uses. May focus on various speciﬁc measures, such as free cash ﬂow (see below). Earnings: Corporate proﬁts, or net income, based on Generally Accepted Accounting Principles (GAAP). Earnings per share, or net income divided by shares outstanding, represent the most popular single indicator of corporate performance. Fiscal policy: Government spending policies that inﬂuence macroeconomic conditions. These policies affect tax rates, interest rates and government spending, in an effort to control the economy. Fundamental analysis: Evaluating a company’s balance sheet, income statements, cash ﬂows, products, economic environment and management to predict future trends in ﬁnancial performance and price of the company’s stock. GAAP (Generally Accepted Accounting Principles): Set of rules, procedures and guidelines for accounting practice, promulgated by the Financial Accounting Standards Board. Financial reporting by public companies is governed by GAAP. Market capitalization: Total value of a company in the public markets at a moment in time. The number of outstanding shares of common stock times the price per share. Monetary policy: The actions of a central bank, currency board or other regulatory committee, that determine the size and rate of growth of the money supply, which in turn affects interest rates. Price/earnings ratio, or P/E: A measure of valuation, the price of a stock divided by earnings per share. May focus on actual past results, trailing P/E, or projected future results, forward P/E. Sharpe Ratio: A ratio developed by Nobel Laureate William F. Sharpe to measure risk-adjusted performance were you subtract the risk-free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. Technical analysis: Study of the supply and demand for a stock or other asset, based on price movements and volume. Many different techniques are used, with the common goal of identifying patterns that indicate trends and changes in trends. Valuation: The process of determining the current worth of an asset or company. There are many techniques that can be used to determine value, some are subjective and others are objective.
Footnotes: 1 Scout Investment Advisors analysis of Russell Equity Index data for large caps, mid caps and small caps, 1985-2005.
Puchkov, AV, Stefek, D, Davis, M, “Sources of Return in Global Investing,” Journal of Portfolio Management, Winter 2005, pp.12-21. Vuolteenaho, T., “What Drives Firm-Level Stock Returns?” Journal of Finance, February 2002, pp.233-264. Abarbanell, JS, and Bushee, BJ, “Fundamental Analysis, Future Earnings, and Stock Prices,” Journal of Accounting Research, Spring 1997, pp. 1-24. Lin, Y, Hsu, Y and Liao, WM, “Dividend Policy and Accounting-Based Valuation,” SSRN Working Paper Series, May 2005. Lin, Ibid.; Penman, SH, and Sougiannis, T, “A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation,” Contemporary Accounting Research, Fall 1998, pp.343-383. Vuolteenaho, Ibid. Cremers, Martijn and Petajisto, Antti, “How Active is Your Fund Manager? A New Measure That Predicts Performance,” June 28, 2006, AFA 2007 Chicago Meetings Paper.
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The UMB Scout Funds are distributed by UMB Distribution Services, LLC, an afﬁliate of UMB Financial Corporation, and managed by Scout Investment Advisors, Inc., a subsidiary of UMB Bank, n.a. MUTUAL FUNDS: NOT FDIC INSURED / NO BANK GUARANTEE / MAY LOSE VALUE Due to the limited focus of this fund and strategy, the UMB Scout Mid Cap Fund and UMB Mid Cap Strategy are more susceptible to market volatility because smaller companies may not have the management experience, ﬁnancial resources, product diversiﬁcation and competitive strengths of larger companies. Additionally, smaller company stocks tend to be sold less often and in smaller amounts than larger company stocks. Products offered through UMB Investment Advisors are: not insured by the FDIC or any other government agency; not a deposit or other obligation of, or guaranteed by, UMB Bank; subject to investment risks, including the possible loss of the principal invested. UMB Investment Advisors is a division within UMB Bank, n.a., that manages active portfolios for employee beneﬁt plans, endowments and foundations, ﬁduciary accounts, and individuals. UMB Bank, n.a., is an afﬁliate within the UMB Financial Corporation.
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