Investing in Mid-Cap Stocks

While many investors get excited about owning shares in small, fast-growing companies, others prefer the stocks of established household names that provide a sense of stability and security. But even the most successful investors tend to overlook a significant portion of the stock market: mid-cap stocks.

Like Goldilocks' chair, medium-cap stocks are the not-too-big, not-too-small companies that are "just right" for investors who want a combination of growth and profitability. If your portfolio already holds a lot of small-cap or large-cap companies (or both), adding some mid-cap stocks can help you to diversify your portfolio.

Here's a closer look at mid-cap stocks, including how to choose the best ones and how to decide if mid-cap stocks are right for you.

What are mid-cap stocks?

Mid-cap stocks are stocks of companies with medium-size market capitalizations or valuations. They're so named because they fall between small-cap and large-cap stocks.

A stock is classified as mid-cap when the total value of all of the company's shares outstanding falls between $2 billion and $10 billion. Here’s how stocks are generally classified by market capitalization:

Mid-cap companies include fast-growing, young companies that have outgrown their small-cap origins, as well as mature companies operating in stable and profitable corners of the market. The COVID-19 pandemic has made technology more important than ever and made previously small businesses into much larger ones. Vaccine rollouts are also helping areas of the economy reopen, which is causing some stocks to rally into mid-cap status.

While small-cap stocks are often fast-growing but volatile, and large-cap stocks tend to be relatively slow-growing but stable, the best mid-cap stocks are often somewhere in between. Mid-cap companies are both less volatile than fast-growing small-caps and have more growth potential than mammoth large-cap companies.

Five great mid-cap stocks and funds to consider

Don't be surprised if you do not immediately know the name of every mid-cap stock that we highlight below. Some mid-cap companies are household names, but many aren't, especially those that operate in specialized industries.

Here are three excellent mid-cap stocks:

• Ambarella (NASDAQ:AMBA) is a relatively small company in a market segment -- semiconductors, or computer chips -- that is dominated by giants. Ambarella isn't a chipmaker itself; rather, it designs components that then get manufactured by its chip fabrication partners. Specifically, Ambarella focuses on computer vision (CV) semiconductors, which use artificial intelligence (AI) to help a computer system “see,” recognize what’s in a field of vision, and make decisions based on that information. Applications include security cameras and autonomous vehicles, with the latter expected to be a huge growth market in the next couple of decades.
• Clover Health Investments (NASDAQ:CLOV) is a fast-growing company in the healthcare insurance space. It became public in January 2021 via a merger with a special purpose acquisition company (SPAC) managed by Chamath Palihapitiya, the former Facebook (NASDAQ:FB) executive turned venture capitalist. Clover currently operates as a Medicare Advantage insurance company but with a twist. Its software integrates directly with healthcare providers' operations, eliminating the layers of bureaucracy that traditionally plague healthcare plans. Although not profitable yet, the company is on a clear path to reaching breakeven and could seriously disrupt the massive healthcare industry.
• Stitch Fix (NASDAQ:SFIX) is a great example of a young, growing company that is no longer classified as small-cap but is still in the early stages of generating positive free cash flow. The internet company sells and ships curated clothing and accessories to its subscribers, using AI to enhance the sales process and match users' preferences with the company's selections. While the clothing and apparel industry took a hit during the pandemic, Stitch Fix bucked the trend and continued growing. It’s reinvesting heavily to maximize its rate of expansion and benefiting from a resurgence in consumer spending on clothing.

Not sure which individual mid-cap stock or stocks to pick? A mid-cap-focused exchange-traded fund (ETF) can help to diversify your portfolio by providing exposure to a wide range of mid-cap stocks. Two of our picks for mid-cap-focused ETFs are:

• Vanguard Mid-Cap ETF (NYSEMKT:VO): This ETF tracks the performance of the CRSP US Mid Cap Index. This fund holds both growth- and value-oriented companies and contains 349 stocks in total. It pays a small dividend and is affordable, with an expense ratio -- the fund's annual management fee -- of just 0.04%.
• iShares S&P Mid-Cap 400 (NYSEMKT:IJK): This fund invests specifically in mid-cap growth stocks. The ETF holds a basket of U.S. stocks (227 in total) with particularly high growth potentials but also relatively volatile share prices. This ETF is an inexpensive option, with an expense ratio of just 0.17% annually.

How to evaluate top mid-cap stocks

Since mid-cap stocks are often former small-cap stocks, the process of finding the best ones is similar to searching for great small-cap companies. Generally you are looking for companies with visionary leaders operating in growing industries, a business model with competitive advantages, and a track record of rewarding investors.

Most importantly, you should see histories of sales and profit growth. If a company is lacking either, make sure to understand why. Below is guidance for evaluating both sales growth and profit growth:

1. Sales growth: For mid-cap companies with growth potential, sales should be consistently increasing over time. That growth shows that the company's business is a good one with the potential to sustain itself. Another good sign is when a company's sales are growing faster than those of larger companies. If sales aren't growing (or rebounding after the pandemic), take that as a warning sign. It's essential to discover a good reason for this before you invest.
2. Profit growth: A stock's price tends to correlate with the company's profits. If a company's earnings are growing, then its stock price typically rises. Of course, fast-growing companies aren't always profitable, and, in those cases, losses should be consistently shrinking as sales grow. If losses are increasing even while sales are rising, then it's important to understand the reasons why. For example, if a business is aggressively investing to expand into a new area, then shrinking profitability might be acceptable for a time.

Are mid-cap stocks for you?

If you can hold an investment for five years or more, are comfortable with occasional price volatility, and are seeking to balance growth with volatility, then mid-cap stocks may have a place in your portfolio.

To get started on investing, do your homework before you buy. If you're not prepared to do the research required to evaluate individual mid-cap stocks, or don't want to devote the time necessary to do so, then consider adding a mid-cap ETF or mutual fund to your diversified portfolio.