Leo Tolstoy’s great novel Anna Karenina begins with the line ‘Happy families are all alike; every unhappy family is unhappy in its own way’. I’d like to offer an investing-oriented version of this sentiment: All large-cap portfolios do well or do badly for the same reasons; every mid-cap portfolio does well or badly for its own reasons. This basic truth, or rather, the reason behind it is something that every mid-cap investor must appreciate.
At Value Research, our analysts’ team has been quantifying this affect by studying the investment portfolios of mutual funds that invest in different sizes of companies. Our team took the universe of all equity funds and studied those that fitted into our ‘Large-Cap’ and ‘Mid & Small Cap’ categories. For these funds, we studied ten different periods, ranging from the previous week to the previous ten years. For each of these periods, we studied the dispersion of the returns generated by these funds. In other words, we studied whether their returns spread along a large range of values or whether they were similar to each other. And we didn’t just judge the dispersion in a subjective manner, but precisely measured the Coefficient of Variance for each set.
The results of the exercise left no room for any doubt. In nine of the ten periods, large-cap funds’ portfolios had a much smaller variance than those of the small and mid-cap funds. And the difference was not small-the variance among mid-cap portfolios in these nine periods was around double that of large-cap funds.
This is such a broad and deep result that there has to be a strong underlying reason. For the equity investor, understanding this reason is of the utmost importance. Mid-cap investing is a risky business because the penalty for choosing the wrong mid-cap is far higher than that of choosing the wrong large-cap. When the markets rise, practically all large caps rise with them. The exceptions are there, but are few. When the markets fall, all large-caps fall but few fall a whole lot more than the general trend. Mid-caps are different. They tend to over-perform and underperform by a larger margin. Mid-cap stocks that underperform tend to do so by huge margins.
But there’s more. When the markets recover and the general trend reverses, all large-caps tend to do follow. However, there are always some mid-cap stocks that don’t recover, or recover poorly or don’t recover at all. There is simply much more variation in mid-cap performance than in large-cap performance.
It is one of the basics of investing in stocks that large companies are fundamentally different from smaller companies. Because few small companies are being intensively researched good news and bad news can be kept well-hidden far more easily and for far longer. When the business environment changes, smaller outfits are liable to be more severely affected, either for the good or the bad. A far larger proportion of small companies’ go into a terminal decline, that is, things turn bad for them and they never recover. Smaller companies’ shares are less liquid than that of large companies. When more than a few investors try to buy or sell the stock, it is likelier that their actions will drive the price, again adding to the variation.
In all these ways, mid-cap investing is a different game compared to large-caps. Both risks and rewards are higher, but I think you already knew that. The important thing is the need for understanding, vigilance and knowledge is much higher. It’s simply a much bigger load of work to invest in mid-caps. However, investors who can bring the required attitude and analytical ethic can hope for an ample pay-off.
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