Mid-cap stocks have been underperforming large companies on the ASX because of the greater volatility, but asset managers expect this pattern to reverse in the longer term.

The S&P/ASX 50, which measures moves in the shares of the largest 50 Australian companies on the ASX, has returned 13.8 per cent over the year to 5 September, while the S&P/ASX MidCap 50 index, which includes the 51st to 100th largest stocks, is up just 3.0 per cent. The S&P/ASX 200 has gained 11.1 per cent.

Jun Bei Liu, portfolio manager with Tribeca Investment Partners, says as a general rule, large-cap stocks tend to outperform their smaller peers during times of uncertainty and volatility as investors minimise their risk exposures and stick with defensive large companies. 

“The recent reporting season has seen many diversified financial companies reporting weaker earnings and outlook, which has led to poor performance, and the same can be said across some of the industrial names also,” Liu says. 

According to Shane Langham, senior private wealth adviser with Phillip Capital and author of the Charting Wisdom share market report, investors are selling down midcaps as we are in a “risk-off” environment, in contrast to the good times when they tend to prefer them.

“The mid- and small-cap end of the market is where people who are after ‘risk-on’ positions will look to get positioned. Likewise, if they are moving to a ‘risk-off’ position, normally you will see mid and small caps get sold off,” he says.

Greater growth prospects

Yet over time, midcaps have outperformed. The S&P/ASX MidCap 50 index has gained 12.4 per cent a year over the five years to 5 September. The S&P/ASX 50 has risen just 7.50 per cent a year and the ASX 200 by 8.0 per cent. Over 10 years, that pattern of outperformance by midcaps is repeated.

According to a recent research paper from Fidelity, The Case for Small to Mid Caps, smaller companies offer the potential to generate excess returns more so than large companies. 

“This is because in a company’s lifecycle the point that revenue and earnings are expanding at their fastest rate is often when it is a rising small- or mid-cap stock. It’s also at this point that its share price often takes its biggest leaps,” says James Abela, portfolio manager of the Fidelity Future Leaders Fund.

“If you can manage the risk of the sector and find the future leaders and avoid the future blow-ups – you can achieve great outcomes for your clients," the paper says.

medical instruments

In terms of current midcaps expected to outperform, the Future Leaders Fund is overweight healthcare stocks ResMed (ASX: RMD) and Pro Medicus (ASX: PME), as well as technology stock Altium (ASX: ALU) and Magellan Financial Group (ASX: MFG). 

Ongoing contract wins in the US and financial results have helped Pro Medicus while ResMed has a strong growth outlook in the sleep apnoea device market. ResMed’s software-as-a-service business for the health sector has also helped to boost its profit margins and brokers expect ongoing strong growth as its share price hits record highs even during the August market volatility.

Altium’s shares too are hitting record highs. The company produces printed circuit board design software for clients globally including Apple, Microsoft, Tesla, Audi, Toyota, BMW, Volkswagen, Cochlear, and ResMed. Reflecting its quick growth, in its recent 2018-19 full-year results, Altium reported a 41 per cent increase in net profit after tax (NPAT) to US$52.9 million ($78.7 million) and earnings per share (EPS) growth of 41 per cent. The business is growing its margins across all key regions and all business segments.  

“By continuing to innovate, the company has won market share and been able to grow revenues and deliver strong returns on capital for investors,” says Fidelity.

Another undervalued stock is Cleanaway Waste Management (ASX: CWY), which is “a quality waste management company that will generate defensive growth and it is trading at a discount to its international peers,” Liu says. 

Diversity on offer

Midcaps also offer greater diversity, as well as greater growth prospects. The larger end of the Australian stock market is highly concentrated by sector and is heavily skewed towards banks and resource stocks. By comparison, midcaps are more diversified, with exposure across a wider range of sectors. 

The S&P/ASX MidCap 50 includes well-known names such as JB Hi-Fi (JBH), Flight Centre (FLT), Xero (XRO), the a2 Milk Company (A2M), Coca-Cola Amatil (CCL), REA Group (REA), BlueScope Steel (BSL), Crown Resorts (CWN), Seek (SEK) and Fisher & Paykel Healthcare Corp (FPK). These are household brands, owned by companies with strong balance sheets, growing businesses and quality management.

Mid caps too are also more likely to be takeover targets than large-cap stocks. “Not only does a takeover offer propel the target’s share prices to unexpected heights; the tendency for larger companies to invest in smaller ones often means that small and mid-caps trade above what they otherwise would,” says Fidelity.