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The compelling case for mid-caps

27th April 2023 10:53

by Anjli Shah from abrdn

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We explain why we believe there is a compelling case for a dedicated allocation to global mid-cap equities.

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Key takeaways

  • Global mid-caps have historically outperformed large caps, including following market selloffs. 

  • Many mid-caps typically sit on the ‘sweet spot’ of the company lifecycle – offering the similar growth potential of small caps with a risk profile more like large caps. 

  • Current valuations are attractive on a relative and historical basis.

Like most risk assets, global mid-cap equities endured a tough 2022. In 2023 so far, they have participated in a tentative recovery. Nonetheless, the global economic backdrop – characterised by weaker growth, elevated inflation, and rising interest rates – remains challenging. Despite this, we think the current environment is an opportune time for investors to consider a more dedicated allocation to mid-cap equities.

We cover the numerous reasons in our latest paper The compelling case for a dedicated allocation to mid-cap equities. However, before you read that, here’s a quick run through the evidence.

Global mid-caps – a brief recap

As the name suggests, mid-cap equities are between large caps and small caps in terms of market capitalisation. Looking at the MSCI All Country World Index (ACWI), large caps represent the biggest segment – 70% of the total market cap. At the other end of the scale, small caps make up 15% of the total index market cap, with mid-caps accounting for the middle 15-30% of the entire global equity market cap1.

However, it’s important to understand that while mid-caps are smaller than large caps, they’re not small. In the global equities context, the average market cap of global mid-caps is US$6.1 billion (bn). This is more than four times the average global small-cap size of US$1.3bn, but just a fraction of the average global large-cap size of US$32.6bn2.

Structural attractions

In terms of risk/return characteristics, global small caps outperform broader global equities and large caps over the long run3. This, though, is at the expense of more risk. Global mid-caps occupy the middle ground. They outperform large caps and trail small caps, but with considerably lower volatility than the latter.

Furthermore, mid-cap companies combine the attractive traits of both large caps and small caps. Like large caps, mid-cap businesses tend to be diversified in terms of products/business lines and regions. This can provide an element of earnings stability. Additionally, the global mid-cap segment contains many recognised, high-quality companies with proven product and service offerings, which can give a degree of pricing power in tougher times. On the flip side, like small caps, mid-caps tend to have more unexplored organic growth opportunities and greater operational flexibility (including the ability to scale up or down) depending on prevailing conditions.

Given these factors, mid-caps typically sit on the ‘sweet spot’ of the company lifecycle. As you can see from the blue-shaded area below, they tend to be early-to-midlife companies – they are often sufficiently well-established to avoid some of the greater risks of small-cap companies, while at the same time have ample growth opportunities and less risk of demand obsolescence/saturation risk that can affect large-cap companies. That’s why a mid-cap allocation within a global equity portfolio can help investors diversify.

Even with these positives, mid-cap equities are a relatively under-researched part of the market, with global equity investors potentially under-allocating to the asset class. This creates significant opportunities for active investors.

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    Why now?

    Aside from the structural benefits, we think there’s also a case for global mid-cap equities in the current economic and market environment.

    Firstly, as a sector, global mid-caps are full of premier companies, with robust balance sheets and good pricing power. This means there’s a large (cross-sector) pool of global companies that are equipped to deal with today’s challenging economic climate.

    Secondly, as shown below, the historically attractive long-term returns of global mid-caps are supported by their track record of bouncing back ahead of large caps, following major drawdown periods.

    midcap abrdn 2.JPGmidcap abrdn 3.JPG

    Thirdly, global mid-caps are trading at relatively attractive valuations. As shown below, global mid-caps have typically traded at a premium valuation relative to broader global equities. Since 2015, they’ve been even cheaper, with a notable increase in the size of the discount in the past two years.

    midcap abrdn 4.JPG

    Final thoughts

    We believe the case for global mid-caps is clear. They offer the higher growth potential of small caps but with the more controlled risk of large caps. These are ideal dynamics for those looking to diversify their broader equity portfolio. Furthermore, the mid-cap sector is home to numerous leading companies, with robust balance sheets and proven earnings capabilities. This means that many are resilient in the current climate. And yet despite these factors, analyst coverage of mid-caps is relatively poor – creating excellent opportunities for active investors. Finally, relative valuations are presently attractive, with global mid-caps offering an increased discount to global equities.

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    1. MSCI Indices, December 2022
    2. Source: MSCI ACWI Large Cap, MSCI ACWI Mid Cap and MSCI ACWI Small Cap index factsheets, 28 March 2023
    3. From 2001 to 2022, MSCI World Mid index returned 315% versus 221% for MSCI World Index and 202% for MSCI World Large Index (Source: Morningstar Direct)

    Anjli Shah is Investment Director at abrdn

    ii is an abrdn business. 
    abrdn is a global investment company that helps customers plan, save and invest for their future.

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