Mid-Cap Stocks: Investing Essentials

The biggest advantage to mid-cap stocks is that they offer a comfortable middle ground between large caps and small caps.

Aug 5, 2014 at 10:22AM

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When thinking about mid-cap stocks, it helps to recall the story of Goldilocks and the three bears. Many investors find that small caps are too "hot" while large caps are too "cold." This draws them to the middle ground, which -- no surprise -- is occupied by mid-cap stocks.

What are mid-cap stocks?

The term "mid-cap" refers to stocks with a medium-sized market capitalization. What does this mean? As Investopedia explains, market capitalization is "just a fancy name for a straightforward concept: it is the market value of a company's outstanding shares." To calculate it, you multiply a company's stock price by the number of shares outstanding.

Take supermarket chain Safeway as an example. At the time of writing, it trades for $34.46 and has 228.8 million shares of common stock outstanding. This yields a market cap of $7.9 billion.

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The standard range for what constitutes mid-cap is between $2 billion and $10 billion. This captures well-known companies such as luxury accessories designer Coach and homebuilder D.R. Horton, as well as lesser-known concerns such as New York Community Bancorp and Tesoro, a petroleum refiner headquartered in Texas.

However, this definition is open to interpretation. This is principally because the threshold for large-cap stocks, which serves as the upper boundary for mid caps, is far from settled. While most sources define large caps as stocks with market caps above $10 billion, the leading large-cap index, the S&P 500, sets it at $5.3 billion. 

How many mid-cap stocks are there?

Any estimate of the number of mid-cap stocks depends on how you define the term. If the range is from $2 billion to $10 billion, then 887 make the cut as of August 2014. If $5 billion is used as the upper boundary, then the universe decreases to 599.

Notably, the number of mid-caps is a moving target. As stock prices rise and fall, companies on the margins can either gain or lose the designation. Office supply chain Staples offers a good example. Its market cap over the last decade has fluctuated between $20 billion on the high end and $7 billion on the low end.

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What drives mid-cap stocks?

Like most stocks, mid-caps are driven first and foremost by the underlying economy. When the unemployment rate is low, more people have more money. This filters back into the coffers of businesses via higher consumer spending, which makes up almost three-fourths of U.S. gross domestic product.

Additionally, both consumer and investor sentiment play a central role in the performance of mid-caps. Like low unemployment, high consumer confidence acts as a catalyst on spending and thus economic activity. Along with this comes the confidence of investors, which can single-handedly boost the value of stocks by staggering degrees.

Finally, given that many companies underlying mid-caps stocks still have considerable opportunity for growth, multiple sector-specific factors play into the equation. How big is the market for the specific company's product? How much of the market does the company control? Is it realistic to assume its market share will grow? All of these issues are central to the question of what drives mid-cap stocks.

What's the advantage of mid-cap stocks?

The biggest advantage of mid-cap stocks is that they split the difference between large caps and small caps. They're like Goldilocks' porridge in this regard.

Because large caps have less opportunity for explosive growth, they tend to distribute a considerable portion of earnings to shareholders instead of reinvesting the funds to fuel growth. This makes large caps more appealing to income investors but less appealing to growth investors.

Small caps do just the opposite. Rather than distributing earnings to shareholders, they typically reinvest that money in their business in order to fuel growth. This slice of the stock universe attracts investors who are interested in capital appreciation.

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Given that mid caps are sandwiched between these two extremes, it stands to reason that they offer a little bit of both. You can see this in the percentage of mid caps that pay dividends compared to their small-cap and large-cap counterparts. 

The takeaway on mid-cap stocks

For investors who want to have their cake and to eat it, too, there's a lot about mid-cap stocks to like. Namely, as a group they offer the opportunity for rapid growth without wholly overlooking many investors' desire for dividends.

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