Investing in Mid-Cap Stocks

While many investors get excited about investing 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' porridge, 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. And if your portfolio already holds a lot of small-caps or large-caps (or both), adding some mid-cap stocks can help you to diversify your portfolio.

Here's a closer look at the basics of mid-cap stocks, 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 a medium-size market capitalization (the cap in mid-cap). They’re so named because they fall between small-cap and large-cap stocks.

We say that a stock is a mid-cap stock when the total value of all the company’s shares outstanding -- meaning the shares held by all shareholders, including company insiders -- falls between $2 billion and $10 billion.

Source: The Motley Fool

Mid-cap companies include fast-growing young companies that have outgrown small-cap status as well as mature companies operating in stable, profitable corners of the market.

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

Mid-cap stocks might not be top performers over short periods, but their combination of lower volatility and higher growth potential often translates into solid returns for mid-cap stock investors over long periods of time.

Five great mid-cap stocks and funds to consider

Don’t be surprised if you don’t immediately know the name of every mid-cap stock you read about. Some mid-cap stocks are household names, of course, but many aren’t, especially companies that operate in specialized industry niches.

Here are some excellent mid-cap stocks to consider:

• Cabot Microelectronics (NASDAQ:CCMP) is a relatively small company in a market segment dominated by giants: semiconductors, or computer chips. Cabot isn’t a chipmaker itself; rather, like the businesses that sold pickaxes to gold-rush miners, Cabot supplies chipmakers with chemicals and cleaning products used in the semiconductor manufacturing process. The semiconductor industry can be volatile, as chip designs come and go, but overall growth of chip production tends to be relatively steady. Cabot’s results have been steady as well.
• Clover Health Investments (NASDAQ:CLOV) is a fast-growing company in the healthcare insurance space, having recently gone public 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 path to reaching breakeven and could majorly 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 turning a profit like its large-cap peers. 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 best apparel. While the clothing and apparel industry has taken a hit during the pandemic, Stitch Fix has bucked the trend and continues growing. It turns a small profit, as measured by its free cash flow, despite reinvesting heavily to maximize its rate of expansion.

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.

• The Vanguard Mid-Cap Index Fund ETF (NYSEMKT:VO) is an ETF that tracks the performance of the CRSP US Mid Cap Index. This fund holds both growth and value companies and contains 349 stocks in total. It pays a small dividend and is affordable, with an expense ratio -- which indicates the fund's annual management fee -- of just 0.04% ($0.40 annually for every $1,000 invested).
• The iShares S&P Mid-Cap 400 Growth ETF (NYSEMKT:IJK) is an ETF that invests specifically in mid-cap growth stocks. The fund 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 stocks. Generally you are looking for companies with visionary leaders, easy-to-see competitive advantages, solid branding, and track records of rewarding investors.

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

1. Earnings growth: A stock's price tends to correlate with the company's earnings -- which is the same as net income minus any preferred dividends. If a company's earnings are growing, then its stock price will typically rise. Of course, fast-growing companies aren't always profitable, and in those cases losses should be shrinking as sales grow. If losses are increasing while sales are rising, it's important to understand the reasons why.
2. Sales growth: For mid-cap stocks with growth potential, sales -- meaning revenue -- should be growing over time. That growth shows that the company's business is a good one, with the potential to sustain itself; what also suggests that the company's business is working is when the company's sales are growing faster than those of larger companies. If sales aren't growing, take that as a warning sign. It's essential to discover a good reason for this before you invest.

Are mid-cap stocks for you?

If you can hold an investment for five years or more, you're comfortable with occasional big ups and downs in price, and you'd like to balance growth with volatility, then mid-cap stocks may have a place in your portfolio.

To get started on investing, remember that it's important to do your homework before you buy, even with mid-caps generally offering more stability than small companies. But if you're perhaps not prepared to do the research required to evaluate individual mid-cap stocks, or you don't want to devote the time necessary to do so, then you can still easily invest in a wide range of mid-cap stocks by adding a mid-cap ETF or mutual fund to your diversified portfolio.