The Compelling Opportunity in Midcaps

Harry MamayskyAdvisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

Investors think about companies as being either large or small. In between those extremes are midcaps. Based on historical performance and fundamentals, midcaps should command more attention.

Academic research long ago identified the size effect: a tendency of firms with small market capitalizations to outperform those will higher market capitalizations over time. An early paper that made this point was Banz (1981), and the idea was popularized in the academic and practitioner factor literatures by the Fama-French 3-factor and 5-factor models.

The general empirical approach to testing the size effect is to sort portfolios of stocks into decile bins based on firms’ historical market capitalizations (the smallest 10% go into bin 1, the next 10% go into bin 2, and so on, until the largest 10% go into bin 10). Then the returns of the 10 size-sorted portfolios are tracked over time. The latter task is made far easier by the rich data repository Ken French makes freely available on his Dartmouth website.

Using his data on size-sorted decile portfolios, and starting the analysis in 1963 (the usual starting point for factor-strategy analysis because the fundamental stock-level data needed to construct these strategies began in 1962), I find that over the last 60 years, small-cap stocks did indeed outperform large caps – exactly in line with the size effect – as small caps (Low 10) earned 11.2% per year while the largest stocks (High 10) earned 10%. Interestingly, the best-performing group of stocks since the 1960s were midcaps (middle-capitalization stocks), as the 5th decile portfolio (Dec 5) was up 12.3% per year.

long returns