Mid caps can add extra dimension to blue chip portfolios

Australia’s biggest companies are an understandable linchpin of a majority of portfolios, but companies just outside that cohort, can provide opportunities to tap into an extra source of both return and diversification.

In fact, analysts at S&P Dow Jones Indices have characterised Australian mid caps as the “sweet spot” of equity investing, a space that offers a balance between the heady volatility of small caps and steady-as-she-goes stability of the biggest stocks.

Their thesis gains support from the total returns of the S&P/ASX Midcap 50, a benchmark for stocks ranked 51 to 100 on the ASX by market capitalisation1.

In the year to July 31, the mid cap index generated a total return of 12.83% versus a 12.35% gain from the S&P2/ASX 50. The difference was bigger in the five years to the same date, with the mid cap index returning an annualised gain of 9.45% compared to a 7.72% gain from Australia’s largest 50 companies.

“Over the past 12 to 18 months, large caps might have outperformed somewhat, but this unusual occurrence was driven by technical events. Banks, for example, rallied on the back of interest rate hikes and BHP became 100% locally listed,” says John Guadagnuolo, fund manager for Antares Equities’ $530 million Ex-20 Australian Equites portfolio.

“Historically, the mid cap index generates the highest capital growth on average of all sub sectors of the Australian market driven by the higher earnings-per-growth it generates over time,” he says.

Household names

Several of today’s household names are former mid caps, which later moved into the ranks of Australia’s largest companies, rewarding investors who recognised their potential early. Examples include buy now, pay later operator Afterpay and global biotech CSL. Cloud accounting software provider Xero is now the 25th largest company on the ASX and Seek is a dominant job listing platform in the local market.

The top-performing mid caps over the past year include data centre business NextDC and logistics software company, WiseTech Global.

“NextDC has been on a tear in 2023. It stands to benefit from the growth of AI as US-based companies such as Nvidia begin to expand and utilise data centres across the globe,” says Jamie Hannah, Deputy Head of Investments and Capital Markets at VanEck Australia.

“WiseTech has continued to deliver strong earnings growth from its core business CargoWise, as well as making two strategically important acquisitions which will expand its product range, and, importantly, strengthen its sustainable competitive advantage in global logistics,” Hannah says.

VanEck’s S&P/ASX Midcap ETF (AXW: MVE), has a specific focus on this part of the local market, with $195.6 million3 in assets at August 10.

Different to small caps

“Mid caps and small caps have some commonality, particularly the dispersion of returns available to investors, but mid caps on average perform better over time as they have generally achieved some sort of maturity in their capital structure,” says Guadagnuolo.

“Small caps can grow a lot at the revenue line but sometimes need to raise equity in considerable quantities to drive that growth. That means a lot of the growth is diluted, whereas with mid caps revenue growth more often translates into EPS growth which compounds over time.”

A typical mid cap has established products or services, a loyal customer base and has garnered industry recognition. 

“Investing in mid caps provides investors with a greater degree of liquidity than small caps. They tend to have higher trading volumes, with the average daily trading volume of the S&P/ASX Midcap 50 being around $23 million versus around $5 million for the Small Ordinaries,” says Hannah. 

“This liquidity is crucial as it enables investors to navigate and buy or sell shares with relative ease. Mid caps also receive more sell-side coverage than small caps, which leads to more efficient pricing.”

Unsurprisingly, mid cap companies are more volatile than their large caps cousins, but their annualised risk-adjusted returns are nonetheless comparable, if not better, 0.48% in the five years to July 31 versus 0.49% for the S&P/ASX 50, rising to 0.79% over 10 years versus 0.59% for the top 50 stocks.

Extra diversification

The S&P/ASX Midcap 50 has a much broader sector representation than the S&P4/ASX 50, which is dominated by banks and miners. By considering mid caps, investors can potentially leverage a wider sweep of industries within the local economy.

In fact, financials and materials sectors made up more than 57% of the market capitalisation of the top 50 stocks at July 31, with the health sector holding the next biggest weighting at just 10.7%.

By comparison, the S&P/ASX Midcap 50 was more evenly spread across sectors with materials (20.1%), industrials (19.2%), financials (15.5%) and information technology (11.2%) making up two thirds of it.

“Materials is the largest sector, but the makeup is quite different to the S&P/ASX 200. Lithium names are much more prominent, with some individual names accounting for 3%-4% of it,” says Guadagnuolo.

“The S&P/ASX 200 is instead dominated by BHP, then Rio Tinto and Newcrest,” he adds.
A broad investment in the top 200 stocks would obviously include mid caps but in relatively small proportions. Indeed, VanEck calculates such an investment would provide around 46% exposure to just the top 10 companies, with an allocation of approximately 12.4% to the midcap space.

Guadagnuolo suggests the key to choosing the mid caps which will outperform, is to look for a solid capital structure, good governance, good clear lines of accountability and for management with experience in the field.

“Ultimately, what we’re trying to assess is the level of sustainable competitive advantage,” he says.
The overarching point for advisers to consider is that mid caps can complement a broader portfolio of blue chips by delivering fundamental drivers of growth that may not exist in companies within the S&P/ASX 50.

1 https://www.spglobal.com/spdji/en/indices/equity/sp-asx-midcap-50/#overview
2 https://www.spglobal.com/spdji/en/indices/equity/sp-asx-50/#overview
3 https://www.vaneck.com.au/etf/equity/mve/snapshot/
4 https://www.spglobal.com/spdji/en/indices/equity/sp-asx-50/#overview