In this episode of Markets in Focus

Mid-cap stocks have been pushed into the background as investors focus on rotation between large and small, and growth versus value. That might mean a missed opportunity. John Indellicate, CFA, Co-Portfolio Manager on Scout Investments’ Mid Cap Equity Team, and Tariq Siddiqi, CFA, Senior Research Analyst on Eagle Asset Management’s Growth Team, join Matt Orton, CFA, Director and Portfolio Specialist at Carillon Tower Advisers, to dig into the case for mid caps at this moment.

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Transcript

Matt Orton:
One of the dominant themes in the market dialogue so far in 2021 has been rotation. Rotation between value and growth, as well as rotation between small-cap and large-cap equities. But one significant part of the equity market has received very little attention despite long-term compelling performance, especially since the March bottom last year. And that part of the market is mid caps.

This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends and developments driving the markets, visit us at marketsinfocuspodcast.com for additional episodes and insights.

Today, I'm joined by John Indellicate and Tariq Siddiqi for a deeper dive into the opportunity set, represented by mid caps and some ways to think about the asset class from a portfolio construction standpoint. John is a co-portfolio manager at Scout Investments with their mid-cap team. And Tariq is a senior research analyst with Eagle Asset Management, small and mid-cap growth team. John and Tariq, thanks for being here today.

John Indellicate:
Thanks for having me.

Tariq Siddiqi:
Glad to be here.

Matt Orton:
Great. And before we really dive into some of the opportunities within mid caps, I think it makes sense to take a step back and really define the mid-cap equity space. So first, maybe John, you can start with the market capitalization range because I think there's a lot of misconceptions around what mid caps actually are.

John Indellicate:
So when we take a look at the Russell Midcap^® Index, the range of companies in that index, they go from $3 billion at the bottom, all the way up to $40 billion at the top. And obviously that number will vary throughout the year as companies grow and shrink. But usually at the time they rebalance the index, $3 to 40 billion is a pretty good range.

Matt Orton:
Yeah. And I think that's much wider than a lot of people realize. So that context is definitely helpful. And just to stick with you, John, on this. Can you also share some of the other unique characteristics that you would put with mid-cap companies?

John Indellicate:
So mid caps are this great combination of the best of both small-caps and large-caps. Stylistically, you're at a place where you've survived being a small cap, but you still have a long ways to go to be a large cap. Diving a little bit more onto that, compared to a small-cap company, you have a better management team, more of a professional manager, someone who's been through a market cycle, who knows how to handle a complex business. And you also have better access to credit markets. You're not solely focused on equity financing and bank loans. You do have those public credit markets open to you. But then relative to a large cap, you still have that better growth profile. You still have a lot of expansion opportunity. You also have a much better takeout potential than large-cap companies do. So again, you have the best of both, the small and the large caps.

Matt Orton:
Yeah. Thanks, John. That's definitely worth reemphasizing, the best of both worlds between smalls and large. And these characteristics are probably related to why mid caps have performed well over the longer term. And even more important though than absolute performance I would say is risk adjusted performance. Tariq, maybe you can dive into the performance profile of mid caps, particularly on a risk-adjusted basis.

Tariq Siddiqi:
Yeah, absolutely. So to me, what's interesting is what we just talked about, the combination of growth stability that this asset class brings. As John said, you're getting best of both worlds. On a risk adjusted basis, this class is quite interesting. And even though this makes sense intuitively, based on what we just talked about, the numbers back it up very nicely. Over a longer term, this class brings great return as well as the best sharp ratio. Return is highest and volatility is lower. Sort of, what's not to like here? As per Bloomberg and Russell data, the Russell Midcaps have the highest Sharpe ratio of 0.53. Whereas Russell Top 200^® at 0.49, and the Russell 2000^® and 2500™ [indices] are well below that.¹ So you really get a good combination of growth and lower volatility with this asset class.

Matt Orton:
Yeah. And I think that's important that you do get a higher Sharpe ratio than the other major parts of the market. And you can see that playing out this year too. Even the small caps are posting one of their strongest quarters or they posted one of their strongest quarters in the first quarter after a record quarter in the fourth quarter of 2020. Mid caps are doing quite well in 2021, with a pretty nice path higher, there's less volatility. And I think a key question is why can mid caps continue to do well going forward? Any thoughts on that, Tariq?

Tariq Siddiqi:
Yeah, I believe we go back to what has been the trend. The economy is recovering. We go back towards a normalization, the macro economic growth will eventually slow down. What we're seeing currently in the macro data is obviously the lapping of some very easy comps from a year ago when the U.S and the world was effectively shut down. We came out of that, things have accelerated, but as we normalize, as you go forward, growth will eventually turn back down towards this longer-term trend. And here's where the growth names and the mid caps will once again shine, versus small and more value type names. In fact, I believe some of that is already starting to happen in the last few weeks as the growth mid-cap names have started to recover.

Matt Orton:
Yeah. And John, related to that, so it's a positive picture, but what are some of the key headwinds and also tailwinds that investors should pay attention to?

John Indellicate:
Sure. So as Tariq mentioned, the reopening dynamic is probably the biggest tailwind for equities in general right now. And as that continues, I think that's going to continue to be a tailwind for all the equities, including the mid caps. The other big tailwind right now is just the continuation of stimulus, both fiscal and monetary. None of these are going to be straight lines and we're going to have put some takes as certain countries reopened faster than others. Maybe we have some variants of COVID that cause some hiccups along the way. But bigger picture, I think we've got the reopening and all the stimulus that will be big tailwinds.

In terms of some headwinds to pay attention to, I see the biggest headwinds right now as supply chain issues and labor availability and cost. These are things that are, they can be a little hard for us in the equity analyst chair to fully appreciate. But one of the benefits of having mid caps is, they tend to be large enough companies that their management teams know how to deal with these issues, work through some of these problems. So even when you see headlines of, oh yeah, supply chains are tight. Our companies tend to have enough redundancy in their supply chain that even if there's some issues, they're able to find work-arounds through these problems. And so we just let our management teams solve these issues, even though they are potential headwinds to returns.

Matt Orton:
Great. Thanks, John. And so, I'm going to change track a little bit. So we've set the background for mid caps. And now I think another key headline that's on everyone's attention is growth versus value. And last year, and this year so far, you've seen pretty big divergences between growth and value. Had a sharp reversal onto value, starting late last year. And that's continuing into 2021. Maybe Tariq, you can share some of your thoughts since I know you work with the growth team in particular, why mid-cap growth has struggled to find some footing this year?

Tariq Siddiqi:
I think, as we saw the prospects of the world open up, the posts of successful vaccination announcements from Pfizer and Moderna, I think it was sometime in the middle of November of last year. There was a heavy rotation towards a smaller, more value, and I would say, just speculative names. And that's not surprising at all because you would expect the smaller, perhaps lower quality names to be able to now weather the storm and come out to the other side. So companies that were having a tough time and the stocks that were beaten down in the ditches, recovered much faster. And again, that is to be expected in the first inning of a re-exhilarating economy. That's investors shifting a lot of their focus on the safer, more quality names in the mid-cap arena, to the smaller, more value names. And that's not even bringing in the craziness that we saw in the retail and the meme stocks and so forth. So that's just expected at that stage of the recovery.

Matt Orton:
Okay. And so, given your focus on information technology then, which is at the epicenter, I'd say, of this rotation on the growth side. How do you look for new opportunities as this is happening or managing companies that you'd like for the long term, but have been caught up in this rotation despite strong fundamentals?

Tariq Siddiqi:
So despite this rotation, fundamentally, we continue to focus on what are the strongest companies that will continue to grow for the next one, two, three years with large addressable markets. We have nibbled on some of the best names by basically going back and asking, okay, a year from now, will the growth rate be as strong, if not even stronger, given some of the major tech themes that we follow. In all likelihood, companies that, within technology, that benefit from cloud computing, cyber security, artificial intelligence, machine learning, semiconductor innovation, alternative energy, these are all themes that will only get stronger for companies in the next few years. So that's where we keep our focused on. However, at the same time, we have been going back and really just questioning assumptions. How sure are we about the competitive positioning? How sure are we on that? The demand that we saw in second half of 2020 wasn't just as a work from home, COVID related surge versus a long-term secular shift in demand.

One must always be willing to question the basic assumptions and gather the facts that confirm that assumption. Or maybe even perhaps more importantly, question the thesis. We go back and talk to management to get a feel for how business conditions are evolving. The supply chain issues that John just talked about, how are they dealing with some of those things? Talk with their customers, what are the customers looking to buy? Where that company may be able to gain some market share. Competitors, you always want to talk to your competitors to see what those guys are saying about the product, et cetera. Look at third parties. So basically go back to what the basic job is. The deep digging to help us understand the positioning of the company, and then try to figure out where we want to be, taking an extra step and buying a little bit more, nibbling a little bit more to build up a full position.

Matt Orton:
Right. So it definitely sounds like there's still opportunities, there's still optimism. So what would you tell a client thinking of moving away from the mid-cap growth space right now? Why should they stay?

Tariq Siddiqi:
Yeah. I believe clients should continue to stay with the mid caps, simply because of what we have talked about. With mid caps, you get the best of both worlds, a solid growth potential, and typically much less volatility, multiple product lines, and often a global customer base. Mid cap companies tend to have better balance sheets to take advantage of the growth prospects. Whereas we as investors don’t have to ask questions like, wait, is there even a business model here? Will this company ever make money? Or, will it survive through a weak macro environment.

Just because we saw a surge in smaller value names, keep in mind, they were value for a reason. We believe that mid caps may give you the best chance to see the solid growth with the solid margin and cash flow potential. Given how truly large some of the tech mega caps have become where growth keeps continuing at such astronomical levels we fundamentally believe a few of our mid caps may become multi hundred billion dollar companies in the next few years and I believe clients will want to be there for that.

Matt Orton:
Right. And so now, John, I want to bring you into the conversation as well, since you're able to lean into both growth and value. So you've probably got even, I'd say a less biased opinion of this debate. So where are you finding opportunities right now? And have the areas that look attractive right now changed over the past few months?

John Indellicate:
Sure. I agree with everything Tariq said, usually value stocks do lead out of that first inning of the economic recovery. The incremental change in their fundamentals is just the greatest. And so you have seen a lot of the value ideas do well over the last six months or so. And some of those ideas have become just more attractive. We're noticing that years of under investments in new capacity in certain commodity areas have made these companies much more interesting, thinking of oil. A lot of the commodities that are going to go into making some of the green energy infrastructure actually work, things like copper and steel. And because of a lot of factors, including some concerns over how much do you want to invest in new things like mines and smelters and refining capacity. If there are going to be carbon costs down the road, the industry has underinvested in putting on new capacity to meet this demands.

And now that we've got the dual tailwinds of new demand vectors from green energy infrastructure, and then just the cyclical demand from the reopening. A lot of these more value, old economy stocks and commodities are starting to be more interesting. Now, all that said, growth has gotten a lot cheaper. And so we're finding a lot of interesting ideas in the growth segment too. In our specific case, we found some healthcare stocks that are very interesting. Having sold off a lot, you can start making a valuation case that you're getting the pipeline, a lot of these stocks for free. And so, that is a really positive risk reward on a healthcare stock, where if all you're paying for is the current drugs that are on the markets, gives you a real positive risk reward that when something in their pipeline becomes economically viable, you can see a lot of upside potential in some healthcare names.

Matt Orton:
Now I want to bring up the big I word, inflation, because that's definitely on everybody's minds. What are your views on inflation over the next 6 to 12 months, Tariq? And maybe you can focus specifically on how that might impact the higher duration information technology sector.

Tariq Siddiqi:
Yeah. The rising rates and inflation, has certainly been painful, no doubt about it. It would have been simply great if there was no volatility. But at the same time, these bouts of volatility do bring about a chance to revisit the best names that were just too expensive by any measure. We go back to the models that we have built in companies that we own, or would love to own. The best in class operators that weren't fairly valued or extremely overvalued. And then we come up with a base case model and try to figure out, what seems like a fair, what's a normal multiple? And what's a normal valuation? Based on history, based on other companies, based on what their prospects are and where we should start building positions.

In the midterm, the rising rates do hurt, no doubt about it, but I believe the market sees these bouts of volatility and the rate scares. And then over time, the fundamentals went out and come back to the front and the company or the companies that keep compounding at, say, 20% top line, with huge addressable markets, will win out eventually. And perhaps, and I'm biased here given I cover the technology sector, but I fundamentally believe tech gives you a lot more shots and goal to have that durable 20% grower potential, for the next few number of years. I’d rather bet on that company that may grow durably and potentially become 20%, 30%, 40% bigger two to three years out than it is right now. And that's how you get over some of these interest rates and inflations issues from my point of view.

Matt Orton:
Right. And John, and kind of the same question. Inflation in the areas of the market that you cover, how has that impacted them and what do you think about it going forward?

John Indellicate:
So an area we really haven't talked about yet is the consumer and the consumer hates inflation. The consumer's held up pretty well the first part of this year. They've gotten stimulus checks. There's been a lot of pent up demand. There's been a lot of savings that have happened from spending that wasn't able to occur in 2020. And so far, the consumer has been just fine. And a lot of consumer companies were reported ridiculously strong results. That said, going forward, once some of that stimulus runs out, once the pent up demand has run its course, the consumer really does not like inflationary periods. You start seeing sticker shock and some of those high ticket purchases start getting dialed back. And you do reach a point where additional stimulus effectively just starts offsetting higher commodity prices. And so if inflation is something that's going to continue throughout 2021, I have some concerns about how consumer and consumer stocks are going to respond.

Matt Orton:
And so maybe one final question then just to close up our discussion. In addition to some of the themes that you just highlighted, what are other risks outside of inflation that investors should be monitoring going forward?

John Indellicate:
Sure. So as relates to inflation, the next effect is, what does the fed do about that? And navigating when you pull back on quantitative easing, when you start raising interest rates and even more so when you start talking about those things. All of those fed policy error potentials are something that should be paid attention to. In that same vein, the federal government stimulus, major tax changes or lack thereof, either way, is something to pay attention to.

And I'm just going to add in there, we're not done with COVID yet. I think everyone's real optimistic about how the vaccines have gone so far. There are variants out there, the UK is seeing a variant that's starting to increase its case counts. There's still a lot of uncertainty just about the course that COVID will take from here. And I think there was an open question of what happens when winter time rolls around again. And we do start getting more into that flu season. An open question on the vaccines is what happens six months after you've had your shots. Do you still retain immunity or are you going to need boosters? So I don't think we're done with COVID, at least the COVID news flow yet. Although I am hopeful, that all these things can work out positively.

Matt Orton:
Thanks, John, for presenting that balanced viewpoint. I think it's always important to put risks in terms of the conversation as well. But I think that does it for today. So thanks very much for your time, John and Tariq, we really appreciate it. And thanks to our listeners for tuning in.

Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insight at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app until next time, I'm Matt Orton.